The reform strips the military-dominated National Security Council (MGK) of its executive powers and turns it into an advisory body.
It also abolishes some anti-terror laws curtailing freedom of thought and expression.
The series of reforms, which Turkey says it will fully implement in 2004, are designed to harmonise the country's human rights standards with those of the European Union.
"This law is a step for democracy and freedom. Our aim is to reach the standards of countries already enjoying first class rights and freedoms," Justice Minister Cemil Cicek said.
The reform package must now be approved by Turkey's president, who chairs the MGK, before it becomes law.
However, it could raise tensions between Turkey's Justice and Development Party (AKP) government and the army, which has led campaigns to overthrow four governments in as many decades.
The army already views the AKP with suspicion because of its Islamic roots.
"If it were a centre-left or centre-right government passing these reforms then I think the army would feel more comfortable," said Ali Tekin, an Ankara professor.
The AKP says it fully supports democratic reform in Turkey and is committed to keeping religion out of politics.
The military has overthrown four
The European Union welcomed the reform as "very positive", but stressed implementation would be the key test.
Brussels says it will not hold accession talks with Turkey without it first implementing a whole series of reforms its parliament has passed in recent months.
Cristina Gallach, spokeswoman for EU foreign policy chief Javier Solana, said: "Our reaction is very positive. Of course we will want to look at the small print and the implementation, but this goes exactly in the direction of fulfilling the
Copenhagen criteria for EU membership."
These criteria set standards for democracy, human rights and the rule of law which every EU candidate must meet.
Many EU reforms are controversial in Turkey as they challenge a state apparatus that often places nationalist unity and staunch secular principles ahead of democracy.
But the AKP has pressed ahead with EU-inspired laws designed to bolster rights and freedoms, particularly for the country's 12 million Kurds.
Turkey's military has fought a decades-long war against Kurdish separatists at the cost of over 30,000 lives.
While applauding the AKP's acceleration of political reforms, some EU diplomats privately say Turkey, on the fringes of the Middle East, should not become a member of the EU because its cultural identity and history are not European enough.
But if Brussels delays accession talks with Ankara, analysts fear it may encourage the Muslim country to follow a more isolationist and eastward-looking path.