The decision by Major-General Richard Huck, commander of the 2nd Marine Division based at Camp Lejeune, ends the prosecution of 2nd Lieutenant Ilario Pantano.
The former Wall Street trader was accused of premeditated murder for what prosecutors maintained was the unjustified killing of the two Iraqis in 2004, near Mahmudiyah.
"The best interests of 2nd Lt Pantano and the government have been served by this process," the Marine Corps said in a statement.
"That's exciting, isn't it?" Pantano's mother, Merry Pantano, said, adding that she hadn't yet spoken to her son about the decision. "Needless to say, we are quite ecstatic."
No worse enemy
Prosecutors alleged Pantano intended to make an example of the two detainees by shooting them 60 times and hanging a sign over their bodies - "No better friend, no worse enemy", a marine slogan.
Pantano contended he acted in self-defence.
"Down at the unit level, there was never a question about Ilario's conduct and whether or not he did the right thing," Charles Ittins, Pantano's civilian lawyer, said on Thursday.
"It was up in the higher echelons. The people removed from combat situations needed to put more trust in their officers rather than assuming they're guilty"
2nd Lieutenant Ilario Pantano's civilian lawyer
"It was up in the higher echelons. The people removed from combat situations needed to put more trust in their officers rather than assuming they're guilty."
An investigating officer concluded in a report to Huck that murder charges should be dropped against Pantano, a former Wall Street trader who rejoined the marines after the September 11 attacks.
Prosecutors allege Pantano killed the Iraqis because he believed they were launching mortars at his troops. Pantano said he shot the men after they disobeyed his instructions and made a menacing move towards him.
Pantano made "serious errors in tactical judgment", the investigating officer Lieutenant-Colonel Mark Winn wrote in his recommendation to Huck, and should face non-judicial punishment for desecrating the bodies by reloading his weapon and repeatedly shooting them.
However, Winn said the accusation that Pantano shot the detainees last year while they were kneeling with their backs to him was not supported by testimony or evidence.
The defendent was said to have
made 'serious judgment errors'
Huck's decision was based in part on autopsies performed on the detainees, Marine spokesman 2nd Lieutenant Barry Edwards said.
"The initial findings of the autopsies did not support the allegation that 2nd Lt Pantano committed premeditated murder," Edwards said. "Rather, the initial findings corroborated 2nd Lt Pantano's version of the events."
Huck could have accepted Winn's recommendation, given some form of administrative punishment or gone ahead with a court-martial. He decided that Pantano should face no punishment for any of his actions.
Meanwhile in Texas, an Army staff sergeant on trial for murder testified on Thursday that he didn't regret gunning down an unarmed Iraqi to save a fellow soldier, but admitted his attempts to make the slaying look like self-defense were wrong.
"I would still to this day fire on that man, sir," Staff Sargeant Shane Werst said shortly before the defence rested in his murder and obstruction of justice trial.
Werst, 32, faces up to life in prison without parole if convicted for the premeditated murder of Naser Ismail in January 2004, which prosecutors say was in retaliation for an Army captain's death earlier that day.