He also proposed demilitarising Kashmir and placing sections of it under United Nations mandate or under joint control.
"It is a very positive development," Mirwaiz Umar Farooq, the influential leader of All Parties Hurriyat Conference (APHC), told AFP.
"Demilitarising Kashmir should be a priority," he said, adding the APHC leaders would meet in a day or two to discuss Musharraf's ideas.
Other leaders also reacted positively.
"It is a path-breaking statement. I welcome it," said Javed Mir, who in 1989 was instrumental in launching an armed struggle against Indian occupation in occupied Kashmir.
"Musharraf is trying to be flexible. He is not insisting that Kashmir should become part of Pakistan. It is a welcome change," said Mir, who renounced arms in the mid-1990s and joined the ranks of the freedom fighters.
On Monday, Musharraf said that as a plebiscite in occupied Kashmir as demanded by UN resolutions dating back decades was not acceptable to India, other options had to be explored.
Occupied Kashmir's pro-Pakistan group Jamiat-ul-Mujahedin, however, ridiculed Musharraf for departing from the plebiscite demand.
"The Kashmir issue cannot be resolved through formulas other than the right to self-determination," a Jamiat press statement said.
Musharraf also ruled out turning the Line of Control (LoC) a permanent border - a position favoured in private by India although publicly it continues to demand full control of the region.
Freedom fighters have long been opposed to converting the LoC into a border.
"I welcome Musharraf's non-acceptance of LoC as permanent border. We (Kashmiris) will never allow that thing to happen," senior leader Shabir Shah, who also supports Kashmir's independence, told AFP.
Shah, who has spent more than 20 years in various prisons for espousing Kashmir's independence from India, said Musharraf's suggestions could provide a solution to the vexed dispute.
On the streets of occupied Srinagar, residents hailed Musharraf's proposals.
"We want peace in Kashmir and it can only come when the dispute is resolved. Musharraf's suggestions can work wonders," said Mohammed Yousuf, a shopkeeper.
Occupied Kashmir is in the grip of a 15-year-old freedom movement that has so far left thousands dead and many more maimed.
"The two countries and Kashmiris should sit down and discuss Musharraf's options or even those Indians or Kashmiris might be having," said Yousuf.
An Indian analyst said Musharraf's comments showed a softening in Islamabad's rigid position on the disputed state.
"He seems to have accepted that Kashmir becoming a part of Pakistan is now a remote possibility. Islamabad's basic position was that Kashmir should be part of Pakistan," said Uma Singh, professor of South Asian Studies in New Delhi's Jawaharlal Nehru University.
"Pakistan seems to have realised that an intransigent stand on Kashmir will not pay them and they have to be more flexible," she added.
Former Indian former secretary Shashank welcomed Musharraf's proposals but said they ought first to have been mooted through diplomatic channels.