Al-Libbi, who had a $10 million bounty on his head as a top al-Qaida suspect, was arrested early on Tuesday morning along with a Pakistani national.
Aljazeera learned that both men were captured after a shootout near the city of Mardan, about 50km north of Peshawar.
Al-Libbi is accused of masterminding two bombings against the Pakistani president in December 2003. Musharraf escaped both attempts, but the attacks killed 17 and injured many more.
Aljazeera's bureau chief in Islamabad, Ahmad Zidan, said it was the first major arrest of an alleged al-Qaida member in a non-Arab country since Abu Zubaydah's capture in 2002.
Musharraf, who came to power in a bloodless military coup in October 1999 and is a key ally in the US-led war on terrorism, said the Libyan was the chief suspect in the bombings against him.
Security officials have described al-Libbi as al-Qaida's operational commander in Pakistan who has led attacks against US forces in Afghanistan.
Pakistan's interior minister with
a photo of Abu Faraj al-Libbi
He was among six suspects identified as Pakistan's most wanted in a poster campaign last year.
Although he was not on the US Federal Bureau of Investigation's most wanted list, al-Libbi is believed to have taken over the role of the arrested Khalid Sheikh Mohammed, who allegedly masterminded the September 11 attacks on US cities and was arrested in 2003.
Al-Libbi was seen on Monday morning with one of his Pakistani guards in Shahdand Baba near Mardan. Witnesses told Aljazeera he was arrested with two other people in the area.
The operation to catch him was carried out by Pakistani soldiers in civilian attire, Aljazeera learned.
A US counter-terrorism official in Washington said of al-Libbi's capture: "He is the third most important after Osama bin Laden and Ayman al-Zawahiri. It's a significant blow to the group."
"After he [Khalid Sheikh Mohammed] disappeared from the scene, [Abu] Faraj took on some of his leadership responsibilities and was instrumental in directing al-Qaida operations globally, including attacks against the homeland."
This picture of al-Libbi was given
to the media on Wednesday
The official said US intelligence played a critical role in al-Libbi's capture.
Secretary of State Condoleezza Rice said the importance of this breakthrough could become more apparent in the coming days.
"I think that over the next couple of days, we will be able to describe that this is a truly significant arrest," she said in Washington.
Bush hails capture
US President George Bush hailed the capture as "a critical victory in the 'war on terror'" in the battle against al-Qaida, and others said it was the greatest blow to the terror network in more than two years.
"Al-Libbi is a top general for [Osama] bin Laden. He was a major facilitator and a chief planner for the al-Qaida network. His arrest removes a dangerous enemy who was a direct threat to America and to those who love freedom," Bush said.
He also praised the Pakistani government and Musharraf for the arrest.
In Islamabad, Pakistani Information Minister Sheikh Rashid Ahmed said the arrest on Monday had already produced a treasure trove of intelligence, and predicted more breakthroughs ahead.
A Pakistani intelligence official said 11 more terror suspects - including three Uzbeks, an Afghan and seven Pakistanis - were arrested before dawn on Wednesday in Pakistan's Bajor tribal region.
The official, who spoke on condition of anonymity, would not say what prompted authorities to launch the raid, or whether it was linked to al-Libbi's capture.
"This is a very important day for us," said Ahmed. "This arrest gives us a lot of tips, and I can only say that our security agencies are on the right track" in the hunt for bin Laden.