"Today marks the first step towards closure on a terrible, tragic legacy for the thousands of First Nations individuals who suffered physical, sexual or psychological abuse," said the national chief of the Assembly of First Nations, Phil Fontaine.
He went on to describe the agreement as "the largest and most comprehensive settlement package in Canadian history."
Around 80,000 former students stand to receive payouts, if the deal is approved by Canadian courts.
Deputy Prime Minister Anne McLellan made the announcement to the jubilation of gathered native leaders in the capital, Ottawa.
“We hope the settlement package will bring comfort and a sense of victory and vindication for the children and grandchildren of survivors as well,” Mr Fontaine said in reference to the damaging legacy that abuse has inflicted on indigenous students and their families.
One-hundred-and-thirty residential schools operated across Canada from 1874 to 1996.
Of them, about 100 could be involved in claims for compensation.
Payments of CA$10,000 (A$11,500), plus an additional CA$3,000 for each year spent in a residential school, will be made available to former students.
Those aged over 65 will be able to apply for a fast-track payment of CA$8,000.
Canada’s residential schools emerged out of the country’s missionary experience, with the government playing a role alongside various Christian organisations until 1969 when total responsibility was assumed by Ottawa.
The schools aimed to ‘Christianise’ indigenous students and prepare them for integration into mainstream society.
Stories of physical and sexual abuse meted out to students abound, with Justice Minister Irwin Cotler describing victims’ suffering as “the single most disgraceful, harmful and racist act in our (Canadian) history.”
For decades, former students have struggled to win justice against a regime which deprived many of the right to freely practice their culture.
Indigenous leaders lay much of the blame for epidemic rates of alcoholism, drug addiction and sexual abuse among succeeding generations at the feet of the schools.
“They too have suffered and witnessed the effects of the residential school legacy.”
Phil Fontaine was one the first to go public with his own story of sexual and physical abuse at the Fort Alexander School in Manitoba, the Canadian Press reported.
But more victims will now be encouraged to come forth and tell of their experiences with the government also setting up a truth and reconciliation forum.
For Mr Fontaine though, the fight is not quite over.
In an echo of Australia’s ‘stolen generations’ experience where indigenous leaders have called for a formal apology, Mr Fontaine is demanding Canadian Prime Minister Paul Martin say sorry on behalf of previous administrations.