The Chicago-based Seventh Circuit Court of Appeals ruled that Dassey was convicted based on a faulty confession coerced out of the then 16-year-old, who has a low IQ and lacked proper representation.
The 2-1 ruling affirms a lower federal court decision that Dassey should be freed, unless prosecutors in the state of Wisconsin decide to retry the case.
Dassey, who is now in his late 20s, was convicted in 2007 for aiding his uncle Steven Avery in the 2005 murder of Teresa Halbach. They were both handed life sentences.
Their story was featured in the Netflix documentary series "Making a Murderer," launched in December 2015. It raised questions about the US legal system and prompted many viewers to believe the pair were unfairly convicted.
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In 2016, a federal court in Wisconsin found that Dassey, over multiple interviews, had been coerced into confessing by police -- and even by an unsympathetic private investigator working for his defense attorney.
Dassey, whom the appeals court said had a mental deficiency that made him easily suggestible, offered various confessions, all differing in their account of his participation in Halbach's murder.
"Dassey's story changes; he backtracks; officers try to pin him down on time frames and details, but they are like waves on the sand," the appeals court wrote in its decision.
"By the time of the trial, Dassey had recanted his confession, and the State had failed to find any evidence linking him to the crime, but he was convicted and sentenced to life in prison nonetheless."
The original district court ruling in Wisconsin had ordered Dassey released within 90 days, unless prosecutors moved to retry the case. The appeals court had stayed that order until it had made its decision.
Wisconsin prosecutors did not immediately say whether they would retry the case.
Avery remains in prison, but his attorneys have been seeking a new trial.
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