Foreign Secretary Margaret Beckett said that London had agreed to a request by UN chief Kofi Annan that Taylor - if convicted -serve his jail sentence in Britain.
Mr Annan expressed his gratitude to Britain for its "statesmanlike decision", telling reporters at UN headquarters in New York that it marked "another step forward in our battle against impunity for the most heinous crimes".
The agreement is crucial, as the issue of where he would he imprisoned had been holding up any decision on whether Taylor would be tried in Sierra Leone or, for security reasons, in another country such as the Netherlands.
"I was delighted to be able to respond positively to the request of the United Nations secretary general that, should he be convicted, Charles Taylor serve his sentence in the UK," Ms Beckett said.
Immediately after Ms Beckett's statement - which she hailed later in Brussels as in the "best traditions" of British foreign policy - Dutch authorities declared that "all conditions set by the Dutch government have been met" for a trial there.
Mixed response
Sierra Leone's Special Court welcomed the offer.
Liberia, which is recovering from years of civil war ended only by Taylor's ouster in 2003, gave a subdued reaction, saying it was focussed on moving his war crimes trial out of west Africa and not on the jailing of the ex-president.
There was no immediate official reaction from the Sierra Leonean government.
The acting spokesman for the UN-backed court in Freetown, Peter Anderson, hailed Britain's decision as "a welcome development" and said it would facilitate the transfer of Taylor's trial to the Netherlands.
But Sierra Leonean survivors of one of history's most brutal civil wars expressed apprehension at the news.
"Irrespective of the British decision to provide jail sanctuary... we still think the entire trial should be at the Special Court premises in Freetown to give those affected by the war (a chance) to see him in the dock," said Alpha Senessie, whose two hands were hacked off by rebels in 1999 at the height of the war.”
Civil Society, an umbrella organization of 120 different groups, also said it wanted Taylor to remain in Sierra Leone.
"We still feel it would be better for Mr. Taylor to be tried here," its head, Festus Minah, said, citing logistical difficulties. "To take him out ...would make a mockery of justice for the common man."
Mr Anderson, the Special Court spokesman, stressed that no formal decision has been made to transfer Taylor yet, saying there were "a couple of steps more to be put in place before such decisions will be taken."
The Special Court requested Taylor's transfer for security reasons.
Such a request has to be approved by the UN Security Council.
Feared warlord
Once one of Africa's most feared warlords, Taylor, 58, is widely considered to have been the single most powerful figure behind a series of civil wars in Liberia and neighbouring Sierra Leone between 1989 and 2003 which left 400,000 people dead.
He has been indicted by the UN-backed Special Court for Sierra Leone on 11 counts of crimes against humanity, war crimes and violations of international human rights.
Specifically, Taylor is accused of sponsoring and aiding rebel groups which perpetrated the murder, sexual slavery, mutilation and conscription of child soldiers in Sierra Leone's civil war in exchange for a share in the lucrative diamond trade.
The Special Court for Sierra Leone, established in 2002, has requested that Taylor's trial be moved The Hague for security reasons.
Such a request has to be approved by the UN Security Council.
Taylor pleaded not guilty to all 11 charges in early April when he appeared before the court in Freetown for the first time.
A spokesman said earlier this month that any trial is unlikely to be held this year.
Explaining her decision in a written statement to parliament, Ms Beckett said new legislation would be required for Taylor to be jailed after conviction.
"My decision was driven by two compelling arguments. Firstly, that Taylor's presence in Sierra Leone remains a threat to peace in that region," she said.
"Secondly, that we are demonstrating through concrete action the UK's commitment to international justice. If we want to live in a just world, we must take responsibility for creating and fostering it."
Britain's decision was welcomed by the New York-based Human Rights Watch.
Its international justice director Richard Dicker said Britain has taken "a crucial step by offering Taylor a jail cell if convicted".