Andrea Yates was sentenced to life imprisonment in 2002 after being found guilty of murdering her five children in 2001.
The new verdict by the Texas appeals court on Wednesday means that she will now be committed to a state mental hospital and held until she is no longer deemed a threat.
The original conviction triggered debate over whether Texas' legal standard for mental illness was too rigid and whether the courts took post-natal depression seriously.
In her first trial, prosecutors had sought the death penalty but could not in the second as the first jury had rejected the death sentence.
Yates drowned 6-month-old Mary, 2-year-old Luke, 3-year-old Paul, 5-year-old John and 7-year-old Noah in the bath of their house in the Houston area of Texas.
Her lawyers said she had suffered from severe post-natal depression and, in a delusional state, believed that Satan was inside her and that killing her children would save them from hell.
The murders took place just weeks after Yates left hospital. She had been admitted on four occasions for severe depression, twice after attempting suicide.
She had been taken off the anti-psychotic medication Haldol by her doctor after her fourth stay in hospital.
Prosecutors maintained that Yates failed to meet the state's definition of insanity: That she was so severely mentally ill that she did not know her actions were wrong.
Her lawyer, George Parnham, called the verdict a "watershed for mental illness and the criminal justice system".
Rusty Yates, who divorced Andrea last year, said: "The jury looked past what happened and looked at why it happened. Yes, she was psychotic. That's the whole truth."