Culminating a years-long rapprochement with the Opec member, Washington will reopen an embassy and remove Libya from a list of state sponsors of terrorism within 45 days.
US-Libya relations turned around after Tripoli decided in December 2003 to give up its weapons programme, and the two nations have repeatedly said since then they would work to restore ties as Libya followed through on its pledge.
"Just as 2003 marked a turning point for the Libyan people, so too could 2006 mark turning points for the peoples of Iran and North Korea," Secretary of State Condoleezza Rice, who is leading international pressure on the two countries to limit their nuclear programs, said in a statement.
Libya, which is led by one-time US antagonist Muammar Gaddafi, badly needs foreign investment in its energy industry. The Opec member welcomed the move, with its Foreign Ministry calling it a "significant step" toward improving all areas of bilateral co-operation.
Ali Aujali, the Libyan Liaison Office chief in Washington, said the decision would benefit US oil companies. "Now I think they can compete with the other companies and they can go ahead with their job in Libya," he said.
As ties warmed, US companies such as Marathon Oil Corp, ConocoPhillips and Amerada Hess Corp last year agreed to terms letting them resume oil and gas production in Libya after a 19-year absence.
Libya handed over two suspects in the 1988 bombing of Pan Am Flight 103 over Lockerbie, Scotland, accepted responsibility for the bombing and agreed to pay about $2.7 billion to families of victims. The UN Security Council voted unanimously in 2003 to lift sanctions imposed on Libya in 1992.
As an interim step in improving ties, the United States in 2004 ended a broad trade embargo placed on Libya in 1986.
The US embassy in Libya was set on fire by a mob in 1979. After declaring Libya a "state sponsor of terrorism," a designation which triggers sanctions, the United States closed its embassy there in 1980, effectively cutting off ties.
A leading Democrat on US foreign policy praised the decision as signalling an incentive to Iran.
"Libya has thoroughly altered its behaviour," Rep. Tom Lantos, the top Democrat on the House International Relations Committee, said in a statement.
"In taking these actions, the United States dramatically demonstrates to the remaining rogue states - and particularly to Iran - that our country takes note of positive changes in behaviour and is more than willing to reciprocate," the Californian added.
But some of the American relatives of those killed in the Pan Am plane bombing voiced outrage and complained they had not been told in advance.
"It is a dangerous move and now they have rewarded the terrorists," said Susan Cohen, whose 20-year-old daughter was killed in the attack. "The only reason they are doing this is oil," she added.
US Assistant Secretary of State David Welch said he understood relatives' anger but he said Libya had fulfilled its obligations. "Libya is out of the terrorism business."
Senator Charles Schumer, a Democrat, said the Bush administration would have to make a "compelling case" that Libya had permanently broken with terrorism before taking them off the list.
But Michigan Rep. Pete Hoekstra, Republican chair of the House Permanent Select Committee on Intelligence, said he had been to Libya several times and witnessed close co-operation by Tripoli in combating terrorism.
The head of Libya's de facto single ruling party said Libya wants to work with the United States to spread democracy around the world.
"We encourage America on the path of co-operation and we hope we will cooperate together through cultural debate to spread democracy around the world together," Mustapha Zaidi, the top official of Libya's Revolutionary Committees, said.