It comes six years after an Israeli raid on a Gaza-bound flotilla that killed 10 Turkish activists.
As well as a multi-million dollar compensation package for the victims, there's also the prospect of a potentially lucrative economic deal between the two countries.
The announcement was made by both countries' prime ministers in separate announcements: in Ankara, and in Rome, where Israeli Prime Minister Binyamin Netanyahu was visiting.
Relations between the allies imploded six years ago after an Israeli naval raid killed ten Turkish activists on board an aid ship, the Mavi Marmara, trying to breach Israel's blockade of the Hamas-controlled Gaza Strip.
Now, the two countries will restore full diplomatic relations.
Israel will pay US$20 million in compensation to the activists' families, and it will allow Turkey to carry out a series of aid projects in Gaza, including a power plant, a 200-bed hospital and a water treatment plant.
Turkish Prime Minister Binali Yildirim welcomed the agreement.
"Very long discussions took place on the subject of the Gaza blockade and a decision has finally been reached with this agreement. Next Friday, our first ship carrying 10,000 tons of humanitarian aid will set sail toward Israel's port of Ashdod. And therefore the embargo there will have been lifted with Turkey's leadership."
But speaking from Rome, where officials finalised the agreement, Binyamin Netanyahu made it clear the naval blockade would remain.
"I'm sure this is an agreement that is good for both sides so I don't want to start quibbling on that but I will say this: the security naval blockade remains in place but we do enable cargo and materiel, and humanitarian material, to come from Turkey or from any other country to Israel. It can come via the sea to Ashdod and there pass through our regulations and our security, and our procedures to Gaza. This was the case and will be the case."
Mr Netanyahu also raised what he called a strategically important move - the prospect of cooperation with Turkey to exploit natural gas reserves worth hundreds of billions of dollars under the eastern Mediterranean.
"It has also immense implications for the Israeli economy and I use that word advisedly - immense implications - for the Israeli economy, and I mean positive immense implications."
United Nations Secretary General Ban Ki-moon, who is on two-day visit to the region in a bid to revive peace talks, welcomed the agreement.
"I welcome today's announcement of the normalisation of relations between Israel and Turkey. This is an important and hopeful signal for the stability of the region."
But the families of two Israeli soldiers killed in the 2014 Gaza war, and whose remains are held in the Gaza Strip, have condemned the government for failing to secure the release of their sons' bodies.
Leah Goldin is the mother of one of them.
"The Israeli government is signing an agreement with Turkey where Hadar and Oron are not part of it. I mean, it should be because it's the cheapest price Israel would ever pay for the return of kidnapped soldiers."
The Turkish aid organisation involved in the 2010 flotilla expressed its disappointment.
Senior Palestinian official Hanan Ashrawi says the deal is based on the self-interest of both parties.
And this Gazan resident also has his doubts.
"The deal is unfair towards the Palestinian people, it only benefits Israel. It primarily serves Israel, and the siege on Gaza will remain as it is. Gaza doesn't just need an electricity plant or a hospital where people can get treatment, Gaza needs many things, it needs a lot of support, not just a hospital, or a passage to let us in and out."
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