Naser Oric, who will be released for time already served, had pleaded not guilty to six charges of war crimes, including murder and cruel treatment of Bosnian Serbs in 1992-93.
He was in charge of forces which tortured and killed Serb prisoners and torched Bosnian Serb villages.
The court on Friday ordered that Oric, who had been in custody since April 2003, "be released as soon as the necessary practical arrangements have been made".
Oric is one of at least half a dozen Bosnian Muslims to have been indicted by the UN war crimes tribunal in The Hague.
His arrest in 2003 marked a milestone for the court, which has faced accusations by Serbs that it is biased against them.
Punishing with pliers
The indictment against Oric said military police under his command beat Serb detainees with metal bars, baseball bats and rifle butts and extracted teeth with pliers.
He is accused of failing to prevent this or punish those responsible.
He is also charged with responsibility for wanton destruction of Serb villages around Srebrenica. Prosecutors say he failed to take reasonable measures to prevent war crimes and to punish those responsible.
Oric is considered a hero by many Bosnian Muslims for spearheading the defence of Srebrenica in the 1992-95 Bosnian war.
Srebrenica, a Bosnian Muslim enclave in eastern Bosnia, later became a byword for mass murder after Serb forces overran the town in July 1995 and massacred up to 8,000 Muslim men and boys in Europe's worst atrocity since the second world war.
Refugee families compensated
Also on Friday, a court in Montenegro issued its first ruling in favour of the families of 150 Bosnian Muslim refugees who had been arrested and illegally deported in 1992, a lawyer said.
The district court in the capital Podgorica ruled to compensate the family of Sanin Krdzalija - one of the refugees who was illegally deported and later killed in a prison camp - with €45,000 ($57,500), lawyer Dragan Prelevic said.
"This sentence is of historic importance, since after 14 years of covering the crime, destroying evidence and silencing by the state institutions, the Montenegrin court has finally faced the truth," he said.
He added that he would appeal the verdict as "the amount of compensation is not enough for the pain these families have suffered".
One hundred and fifty Muslims fleeing war in neighbouring Bosnia were arrested in Montenegro and deported in early 1992.
The refugees were handed over to Bosnian Serb forces and 81 were subsequently killed.
Plaintiffs representing the families of the victims are claiming €40 million in compensation.