Announcing the move on Monday, the US secretary of state said Libya would also be removed from the US blacklist of states that sponsor terrorism.
"We are taking these actions in recognition of Libya's continued commitment to its renunciation of terrorism," Condoleezza Rice said, adding that
Tripoli's co-operation had been "excellent".
Libya, for its part, has welcomed the US decision as being in the "mutual interest" of both countries.
The restoration of ties is the culmination of a process that began in 2003, when Libyan leader Colonel Muammar al-Qadhafi surprised the world by agreeing to dismantle his country's weapons of mass destruction programmes.
"As a direct result of those decisions, we have witnessed the beginning of that country's re-emergence into the mainstream of the international community," Rice said.
"Today marks the opening of a new era in US-Libya relations that will benefit Americans and Libyans alike."
"Just as 2003 marked a turning point for the Libyan people, so too could 2006 mark turning points for the peoples of Iran and North Korea"
US secretary of state
Signalling that similar incentives could be on offer elsewhere, she called on the leaders of Iran and North Korea to follow the "strategic decisions" taken by Qadhafi.
"Just as 2003 marked a turning point for the Libyan people, so too could 2006 mark turning points for the peoples of Iran and North Korea," Rice said.
The United States has not had formal diplomatic relations with Libya since 1980, although a thaw in long-standing hostilities led to Washington opening a diplomatic office in Tripoli in 2004.
Commenting on the move, Abdurrahman Shalgam, the Libyan foreign minister, said the decision would "certainly open a new chapter in the relations of the two countries".
Shalgam said the decision was "a result of contacts and negotiations. It is not unilateral. It is a result of mutual interests, agreements and understandings."
Asked if the US decision was an incentive for Libya to further co-operate with the United States, he said: "In politics there is no such thing as a reward but there are interests."
A 45-day public comment period will begin on Monday, after which Libya would be removed from the list of countries Washington considers state sponsors of terrorism.
Libya was held responsible for the bombing of Pan Am flight 103 in 1988, which claimed 270 lives, most of them American.
Libya agreed to compensate the
families of Pan Am 103 victims
Libya's economy has been hard hit by years of sanctions and the country badly needs foreign investment in its energy industry.
Faced with rising energy prices, the US meanwhile is eager to diversify its sources of oil and tap into Libya's large reserves.
Ali Aujali, the head of the Libyan liaison office in Washington, said the restoration of diplomatic ties would benefit US oil companies.
"Now I think they can compete with the other companies and they can go ahead with their job in Libya," he said.
However, a spokesman for the Libyan opposition in exile said the US was "unfortunate".
"This doesn't help the Libyan people who are looking for international assistance to achieve their human rights," said Fayez Jibril of the Libyan National Congress.
"Colonel Qadhafi will most certainly use this to tighten his hold on the Libyans who aspire for such simple things such as freedom of expression and freedom to have a constitution," Jibril said from his exile in neighbouring Egypt.