The Italians won the shootout 5-3. The match was tied 1-1 at fulltime and after 30 minutes of extra-time.
French skipper Zinedine Zidane was sent off in the second period of extra-time for head-butting Italian defender Marco Materazzi in the chest.
Ironically Zidane and Materazzi were the only goal scorers during the see sawing match.
Rome celebrations
Italy's win sent fans around the world in a frenzy as they celebrated the Azzuri's close victory.
In Rome, tens of thousands of Italians flocked onto the streets in joy after their team's win.
Immediately after the final whistle, delirious supporters crowded into Piazza Venezia in the centre of the Italian capital to vent their delight and relief.
In nearby Bibo's Bar across the road from Prime Minister Romano Prodi's party headquarters, delirium broke out after Italy's full-back Paolo Grosso buried the decisive penalty.
"It's been a match of intense suffering but we've won it now, and everything's great," shouted waiter Carlo Dilizio, 47, above the din as fireworks rent the moonlight sky.
"I bought an Italian flag in 1982 (the last time Italy won the World Cup) and I took it out of the drawer the other day to show my son. And I said, let's write 2006 on it, and hope," said Carlo.
An Italian TV commentator declared that watching the tense match had caused great suffering: "soffertissimo!"
At the ancient Circus Maximus, more than 150,000 people who watched the game on giant screens at the ancient Circus Maximus across the city exploded with joy at the victory.
"I don't believe it. It's a fairytale, it's just great to win after suffering so much. It's magnifico!" bayed 29-year-old Chiara.
"It's the most beautiful emotion of my whole life, we're the world champions," shouted Giovanni, 23.
French deflated
Meanwhile, thousands of French football fans crammed into the famed Champs-Elysees boulevard in Paris watched in stunned disbelief as their team lost.
Deflated, and angry at the red-card exit of star player Zinadine Zidane, they milled around in distress after the final whistle blew in Berlin to dash their hopes of victory.
The dejection on their faces spoke volumes. With the game coming down to penalty shootouts, they had harboured hopes right to the end of beating Italy to take the trophy.
Zidane's expulsion from the game for an incomprehensible headbutt to the chest of Italian player Marco Materazzi was foremost in the minds of many.
"I just cannot understand what was going through Zidane's head, it just doesn't make any sense," said one fan, Cyrille Bonet.
His brother, Emmanuel, added: "Italy didn't deserve it but it's typical of the Italians, they played terribly for the whole match and then they win it on penalties."
When Italy scored the final penalty settling the game, the atmosphere in cafes, bars, restaurants, homes suddenly went flat - a far cry from the cheers and tense epithets that accompanied the play.
Interior Minister Nicolas Sarkozy said just before the match that French police were "ready" should the crowds turn violent.
He said 12,000 police and military personnel were mobilised across the country, with 3,000 in Paris alone and another 3,000 in the capital's suburbs.
Jubilation in Sydney
In Sydney, an almighty roar marked the realisation of Italy's World Cup dream by up to 10,000 patriots who packed into their Sydney heartland to watch their team claim victory.
Red flares and fireworks lit up the icy Sydney morning above Norton Street at Leichhardt as friends embraced strangers in a crush of Italian jubilation.
Standing outside the Martini Bar, atop a car sporting the red, white and green of the Italian flag, a group of 20 young Italian men screamed and hugged each other.
"It's a dream come true," said 21-year-old Simon Kay of Greystanes.
"It's about time Italy put itself on the richter scale - we showed the world what we're made of."
Almost 8,000 people simultaneously screamed in joy in Melbourne's Lygon Street as Italy won.
As Italy made its fifth penalty goal in a row, the crowd began screaming, hugging each other, jumping up and down and chanting "Italia" at the top of their voices and several flares were set off.