Secretary of State Condoleezza Rice said Libya would also be taken off a US list of nations accused of supporting terrorism.
The United Nations imposed international sanctions on Libya after the Lockerbie passenger jet bombing in 1988 and other attacks that were blamed on Col Gaddafi’s government.
Ms Rice called the renewal of ties one of the "tangible results" of Col Gaddafi 's decision in 2003 to renounce terrorism and abandon efforts to make weapons of mass destruction.
"I am pleased to announce that the United States is restoring full diplomatic relations with Libya. We will soon open an embassy in Tripoli," Ms Rice said in a statement.
"In addition, the United States intends to remove Libya from the list of designated state sponsors of terrorism. Libya will also be omitted from the annual certification of countries not cooperating fully with United States' anti-terrorism efforts," the top US diplomat said.
Ms Rice added: "We are taking these actions in recognition of Libya's commitment to its renunciation of terrorism and the excellent cooperation Libya has provided to the United States and other members of the international community in response to common global threats faced by the civilized world since September 11, 2001."
Libyan Foreign Minister Abdel Rahman Shalgham hailed the move. "This turns a new page (between the two countries), in the interests of both peoples," Mr Shalgham told news agency AFP from Tripoli.
Iran, North Korea
Secretary Rice highlighted the move as an example for Iran and North Korea, which the United States has branded rogue nations and sponsors of terror activities.
"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," she said.
"We urge the leadership of Iran and North Korea to make similar strategic decisions that would benefit their citizens."
Washington severed ties with Libya in 1981, two years after radical students ransacked the US embassy in Tripoli.
An alleged Libyan-backed attack on a Berlin disco popular with Americans in 1986 spurred the US to launch air raids against Tripoli, killing 41 people.
Libya's alleged involvement in international terrorism surged to the forefront when a Pan Am passenger jet was blown up over the Scottish town of Lockerbie, killing 270 people in the plane and on the ground.
Following UN pressure, two Libyans eventually stood trial for the attacks at a Scottish court sitting in the Netherlands. In 2003 Tripoli agreed to pay the families of the dead victims millions of dollars each in compensation.
Those steps led to the cancellation of UN sanctions and the slow warming of relations with Washington.
After Col. Gaddafi agreed to open up Libya's weapons production sites to US and British experts, the US opened a special interests section in Tripoli in February 2004. This was upgraded to a "liaison office" the same year.
Still seeking justice
Some families of Lockerbie victims voiced resignation about the US decision. "It's not a surprise, it's surprising it took this long," said Robert Monetti, whose son was killed in the attack.
"I don't think I will ever be really comfortable with Libya. The people who blew up Pan Am 103, the ones that were responsible for it, have never been brought to justice. But it is what it is. The countries can not stop doing business just because of things like this," he told AFP.
John Zwynenburg, who also lost a son on the doomed flight, said it was a good thing. "It's a positive step. It's better to make peace with other nations than going at war with them. Hopefully we'll continue to help them improve their relations with other nations," he said.
Some family members said those behind the attack had not all been brought to justice and that Libya had not finished making the payouts.
"Libya has not completed their obligations in paying their penalty. They took the money out of escrow and took it back," said Mary Kay Stratis, who lost her husband in the bombing.
"They have not completed their punishment phase in paying for the price of causing the bombing of Pan Am 103," she said.
But Susan Cohen, whose daughter, a 20-year-old university student, died in the bombing, was dismayed by the warming of relations. "I am absolutely sick. Gaddafi can now dance a triumphant dance. He has won," she said.