The Nobel Committee said on Friday it honoured Shirin Ebadi for promoting democracy, religious and political freedom, and defending the rights of women and children.
"She has displayed great personal courage as a lawyer defending individuals and groups who have fallen victim to a powerful political and legal system that is legitimised through an inhumane interpretation of Islam," the committee said.
Opponents of the Iranian government say it is an illegitimate theocracy that has stifled political and religious dissent.
They say Iran under the Ayat Allahs has oppressed women by denying them legal equality and the right to dress as they wish.
But supporters of Islamic Iran say it is the freest and most politically representative country in the region.
Shirin Ebadi, 56, has emerged in the last two decades as one of Iran's most prominent pro-reform activists.
She has spearheading a drive to provide greater legal rights to women and children, and has defended dissidents that few other lawyers would touch.
Prior to the 1979 Islamic revolution, she made headlines when she became the country's first female judge.
But she was stripped of her post when the new ruling clerics decided women were unsuitable for such responsibilities - a decision they later revoked.
Rather than retire to a life of obscurity or flee overseas, Ebadi continued to lecture in law at Tehran university and went back to working as a lawyer.
She became a driving force behind the reform of Iran's family laws, notably on divorce and inheritance, and also against a system where compensation for an injury or death for a woman is half that for a man.
Ebadi also emerged as an unofficial spokesperson for some of Iran's women, who demonstrated their political clout in 1997 by rallying around Muhammad Khatami and electing him president.
But it was involvement in investigating one of Iran's most controversial cases - the 1999 serial murders of writers, intellectuals and dissidents - that put her on a collision course with the county's establishment.
"She has displayed great personal courage as a lawyer defending individuals and groups who have fallen victim to a powerful political and legal system that is legitimised through an inhumane interpretation of Islam"
Nobel Prize Committee
She served as lawyer for Dariush and Parvaneh Foruhar, a couple who were among several dissidents murdered in a spate of grisly killings that were eventually pinned on "rogue" Iranian agents.
In June 2000, Ebadi was arrested for allegedly distributing a taped confession of a hardline vigilante militia member involved in anti-dissident violence.
She was held in jail for three weeks, and then a closed-door court handed her a suspended prison sentence of five years and barred her from practising law.
In its profile of Ebadi, the Nobel Committee said: "(She) is well-known and admired by the general public in her country for her defence in court of victims of the conservative faction's attack on freedom of speech and political freedom.
"Ebadi represents reformed Islam, and argues for a new interpretation of Islamic law which is in harmony with vital human rights such as democracy, equality before the law, religious freedom and freedom of speech."
But Zafar Bangash, director of the pro-Iran Institute of Contemporary Islamic Thought, said harsh criticism of Iran was unjustified.
He said: "Iran is still an evolving society. Since 1979 it has been through a revolution, an eight-year war and vicious economic sanctions. It is under enormous pressure from all sides and cannot be expected to be as politically mature as more established nation states.
"There are certain people in the country who would like to sell Iran down the river to the West and see the Islamic state overthrown. But they are a very small minority indeed.
"But if you believe the western press and governments you would think these people are in the majority. The truth is most Iranians want to see the Islamic system reformed rather than overthrown."
And Bangash said despite real economic, political and social problems, Iran is the freest country in the region.
"Women aren't marginalised in Iran," he said. "In fact they play an active role in all spheres of life. One of the vice presidents is a woman. There is a very large female representation in universities, and in hospitals there are more women workers than men
"I just don't know how people can make these sweeping statements - Iran has the highest representation of women in parliament in the world.
"Iran is still an evolving society. Since 1979 it has been through a revolution, an eight year war and vicious economic sanctions. It is under enormous pressure from all sides and cannot be expected to be as politically mature as more established nation states"
Institute of Contemporary Islamic Thought
However, Bangash admitted Iranian leaders have made mistakes.
"It is true that newspapers have been shut down and I am not comfortable than that. The argument is that Iran is insufficently secure as a society to tolerate a certain level of dissent which could undermine the system itself. But I would prefer to see the newspapers function normally.
And he said that despite the challenges facing the country, Iran was heading in the right direction.
"The Iranian revolution has freed the Iranian people from foreign domination. It is perhaps the only Islamic country in the world, apart from Malaysia, that is free to follow its own policies without foriegn manipulation.
"It is also trying to implement an Islamic system which the majority of Iranians yearn for."
Shirin Ebadi has undoubtedly highlighted some of the more unsavoury aspects of Islamic Iran.
Few doubt that most Iranians would agree change is desperately needed in their society.
But supporters of the Iranian government argue Western critics have a hidden agenda in slamming the Islamic republic.
They say it is not supposed rights inequalities that are behind the continual carping.
It is Iran's very independence that really irks them.