The unexpected choice has drawn some criticism, while others, such as Indian-born author Salman Rushdie, say he is a truly deserving recipient.
He has been described as the voice of a generation.
Bob Dylan's poetic lyrics have influenced fans around the world for more than half a century.
But the decision to award him the Nobel Prize for Literature was met with both gasps and applause from the audience gathered for the prestigious event.
The Swedish Academy cited the 75-year-old artist for what it called "having created new poetic expressions within the great American song tradition."
Permanent Secretary Sara Danius explained exactly why Dylan was selected for the honour.
"He is a great poet. He is a great poet in the English-speaking tradition, and he is a wonderful sampler, a very original sampler. He embodies the tradition, and, for 54 years now, he has been at it, and reinventing himself constantly, reinventing himself, creating a new identity."
It is the first time in the 115 years of the prize that the award has been handed to a songwriter.
Bob Dylan's name now goes alongside former winners and giants of literature such as Ernest Hemingway, John Steinbeck and Jean-Paul Sartre.
University of Chicago music professor Steven Rings says the move is set to challenge people's ideas of what constitutes literature.
"I think it's a bold move for the Nobel. It's, no doubt, going to generate controversy over what counts as literature. By and large, people know him through his songs. And I think, in our culture and certainly the kind of elite culture that surrounds something like the Nobel Prize, we tend to separate out literature from performance. Literature is something that you read on the page. But there's, of course, an extremely long tradition of performed literature, going all the way back to Homer."
Bob Dylan has released 37 studio albums and 58 singles, as well as 11 live albums.
Songs such as Blowin' in the Wind, The Times They Are a-Changin' and Like a Rolling Stone captured a spirit of rebellion, dissent and independence that swept across the '60s.
More than 50 years on, Dylan is still writing songs and is often on tour.
But not everyone is happy with the decision to award him the Nobel prize in a category traditionally reserved for authors.
A New York Times bestselling author, Suki Kim, has criticised the decision, tweeting:
"Is the Nobel Literature committee run by a bunch of old white men who spent the 1960s smoking dope,* listening to Dylan? It's unbelievable that songwriting from the US (is) considered more literature than any of the lifelong works of non-Western novelists and poets."
But Indian-born author Salman Rushdie, often tipped as a possible Nobel winner himself, has praised the decision on social media, describing Dylan as a great choice.
And US president Barack Obama also tweeted his congratulations to Dylan, who he describes as one of his favourite poets.
Bob Dylan has always been an enigmatic figure.
He was born into a Jewish family, converted to born-again Christianity in the late 1970s, then later said he followed no organised religion.
He went into seclusion for months after a motorcycle crash in 1966, leading to stories that he had cracked under the pressure of his new celebrity.
He is yet to respond publicly to the news of the Nobel win and yet another notch of fame.
