The move is also aimed at helping unelected Palestinian Prime Minister Mahmoud Abbas, better known as Abu Mazen, deflect accusations from the two banned groups that he is making too many concessions for peace.
Israeli Prime Minister Ariel Sharon will present the measures to US President George W. Bush in talks scheduled for Tuesday, Reuters reported.
News of the move was immediately dismissed by Palestinian factions.
6000 Palestinian prisoners
“We reject this position and we do not consider it an initiative by the Israeli government,” Mohammed al-Hindi, an Islamic Jihad leader in the Gaza Strip told Reuters.
“It is like someone is trying to throw dust in our eyes,” he said.
Ismail Haniya, a senior Hamas leader, insisted his movement would not be satisfied until all prisoners were released.
There are currently some 6,000 Palestinian prisoners languishing in Israeli jails.
The Israeli government approved the release of prisoners with no "blood on their hands" in a 14-9 vote yesterday shortly before Sharon left to discuss the “road map” in Washington.
Initial reports suggested only 100 prisoners would be released.
Instead, a total of 540 prisoners will be freed, of which 240 are members of Hamas and Islamic Jihad, and 210, members of President Yassir Arafat Fatah faction.
“This is a positive step from the Israeli government and we hope that we will see further batches of Palestinian prisoners from Israeli jails,” Palestinian Information Minister Nabil Amr told Reuters.
The release of members of Hamas and Islamic Jihad, both organisations that deny the right to existence of the Israeli state, is a move away from the Israeli government’s initial approach to the “Road Map.”
The move was spurred in part by Abbas' visit to Washington Friday, which marked the start of a new Palestinian-US relationship.
Bush views Abbas as a moderate and has applauded his successes in curbing attacks on Israel.
The Roadmap envisages the creation of a Palestinian state by 2005.