With 99 percent of votes counted, Mr Olmert's party was set to win 28 of the 120 seats against 20 for the centre-left Labor party.
Likud, which had dominated power for three decades, was dumped in fifth place with 11 seats, behind the ultra-Orthodox Shas on 13 and nationalist Yisrael Beitenu with 12.
The result means Mr Olmert will have little option but to invite Labor into a coalition and other smaller parties, including the Pensioners' Party run by an ex-Mossad spy, a surprise package which netted seven seats.
Asi Shariv, a senior official in the prime minister's office, told news agency AFP that Kadima had already formed a coalition negotiations team.
President Moshe Katsav said he would host a first round of coalition talks on Sunday.
Low turnout
Following a lacklustre campaign in which the result was seemingly a foregone conclusion, turnout was at a record low 63 percent.
But despite securing the premiership in his own right, commentators said Mr Olmert's victory was hollow.
"Ehud Olmert was given a punch in the nose," said an editorial in the top-selling Yediot Aharonot. "The voters accepted him and his plan, but did so with a decided lack of enthusiasm."
Separation plans
Kadima party was formed back in November by Prime Minister Ariel Sharon after he left Likud. Soon after he called an election a year ahead of schedule.
Acting Prime Minister Ehud Olmert has campaigned on a platform to set the permanent borders of Israel, with or without negotiations with the Palestinians.
Mr Olmert's separation plan could ultimately see Israel uproot around 70,000 settlers living in isolated West Bank settlements.
In return, Mr Olmert wants to cement control over the big housing blocs which are home to the rest of the quarter of a million Israelis who have settled in the Palestinian territory since occupation began in 1967.
Dov Weisglass, a senior advisor in the prime minister's office, said there was a clear majority in parliament for Mr Olmert's plan.
"I believe that the coalition will be made up of -- or can be made up at least of -- those political bodies who can and will be prepared to support such a plan."
In his victory speech, Mr Olmert reiterated his agenda.
"We will strive to bring about the establishment of the final borders of Israel as a Jewish state with a permanent Jewish majority, and as a democratic country.”
He said he was ready to compromise in the quest for Middle East peace and urged the Palestinians to exercise the same spirit.
"If the Palestinians agree to act soon, we will sit at the negotiating table in order to create a new reality in our region. If they do not, Israel will take its fate into its own hands."
Palestinian leader Mahmoud Abbas responded to the result with an appeal for Mr Olmert to abandon his plans to act unilaterally.
Mr Abbas urged the next government to "change its attitude and adopt a policy based on a negotiated peace and international law."
But the chances of progress in the stalled peace process appear remote with a Palestinian government led by Hamas -- the Islamist group behind dozens of suicide attacks which does not recognise Israel -- due to be sworn in.
Incoming Hamas premier Ismail Haniya made clear he would not accept a map drawn by Israel and the movement's supreme leader Khaled Meshaal said the price for peace was Israel's total withdrawal from Palestinian land.
Mr Bush offered his congratulations to Mr Olmert in a phone call, inviting him to "visit Washington at his convenience after he gets the government formed," said White House spokesman Scott McClellan.
The Arab summit in Khartoum, however, endorsed a resolution calling for the rejection of Israeli action, including "fixing Israel's borders unilaterally in a way that fulfils its expansionist greed."