Oman, a non-Opec producer of oil and natural gas, signed a trade pact with the United States, which is pressing countries in the Gulf Arab region to do more to protect the rights of workers, mostly low-wage labour from Asia.
Oman's reforms could add to pressure on other states in the world's main oil exporting region, which are also negotiating trade pacts with Western countries.
The official Oman news agency said Sultan Qaboos issued a decree amending the labour code on Saturday and local newspapers published details of the reforms on Sunday.
The decree allows workers to form trade unions to protect their rights and lobby for better working conditions. The unions will be independent and union representatives cannot be dismissed or punished for their role.
"The [labour] minister will issue a decision allowing collective bargaining to settle disputes and improve working conditions and qualifications, as well as peaceful strikes and shut downs," al-Watan daily quoted the decree as saying.
The sultanate has a population of about 3 million and foreigners make up about 75 per cent of the private sector workforce.
Washington has been urging Gulf states to amend worker rights laws to conform to International Labour Organisation standards, to qualify for free-trade pacts.
The US senate approved the trade pact with Oman last month. A vote by the full US House of Representative is due this month on the pact, designed to increase bilateral trade which stood at about $1 billion in 2005.
Oman's neighbour, the United Arab Emirates, is seeking a free-trade pact with the United States. The UAE has said it is amending its labour laws but that it is not willing to make any political concessions to secure the agreement.
Labour rights were also a stumbling block in Washington's free-trade talks with Qatar. It froze negotiations in April and said the United States needed to be more flexible.