It aims to create direct links between China and the Arabian Sea and boost the sluggish Pakistani economy.
The agreement was reached during a meeting in Islamabad between China's President Xi Jinping and Pakistan's Prime Minister Nawaz Sharif.
The $58 billion investment plan would see China and Pakistan jointly fund the creation of road, rail and pipeline links connecting China to the Arabian Sea.
Pakistan's Prime Minister, Nawaz Sharif, said the corridor would have long-term benefits for both countries.
"This corridor will benefit all provinces and areas in Pakistan and transform our country into a regional hub and pivot for commerce and investment," Mr Sharif said.
"It will also enable China to create a shorter and cheaper route for trade and investment with South, Central and West Asia and the Middle East and Africa," he added.
The upgrade would stretch 3,000 kilometres from China's western city of Kashgar to the Pakistani port of Gwadar.
The project would effectively cut several thousand kilometres off the present route transporting oil from the Middle East to China.
China's President Xi Jinping said it was a major step forward in the relationship between Pakistan and China - two countries that have never been traditional allies.
The economic corridor, a network of roads, railways and pipelines, would run through Pakistan's developing Baluchistan province.
The area has long been plagued by a separatist insurgency.
During the meeting, President Xi was expected to raise concerns over Muslim separatists from Xinjiang exploiting the corridor to forge closer ties with Pakistani militants in Baluchistan.
But the Chinese leader moved to allay these fears.
"The Chinese side highly appreciates the Pakistani side's outstanding contribution to the international counter-terrorism efforts," President Xi said.
"We support the Pakistani side to move forward its counter-terrorism strategy in light of its own national conditions and are prepared and willing to continue to help the Pakistani side to strengthen capacity and its ability to fight terrorism," he added.
Prime Minister Sharif said he was grateful to President Xi for appreciating Pakistan's efforts to counter violence in the region.
"He also recognised the sacrifices being rendered by the Armed Forces and people of Pakistan in our effort to root out the menace of militancy and terrorism", Mr Sharif said.
"We have resolved to continue to cooperate to fight terrorism until we have cleansed our soils of this evil. I assured President Xi that Pakistan considers China's security as important as its own security," he added.
The two sides have also agreed to strengthen cooperation in civil nuclear energy, space and maritime technology and defence.
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