The decision, announced by Ehud Olmert's office after two days of talks with the Labour leader, Amir Peretz, should prevent the collapse of the coalition which is under fire over its handling of the Lebanon war.
Olmert's office said in a statement that Peretz "announced at the end of the meeting he would recommend to the Labour party that it approve its continued participation in the government".
Labour was offered several incentives to remain, including additional benefits for the country's Arab population.
Peretz, who is also Israel's defence minister, made no remarks himself after the meeting.
The Labour leader had faced calls from within the party to leave the government after Olmert decided this week to bring in Avigdor Lieberman and his far-right Yisrael Beitenu party.
Lieberman, who lives on a Jewish settlement in the occupied West Bank, advocates the transfer of land and populations to create homogenous Jewish and Palestinian states, policies that Labour opposes.
Opinion polls have shown Labour, along with Olmert's centrist Kadima party, would fare poorly if elections were held now. With Yisrael Beitenu on board, the number of coalition seats in the 120-member parliament would rise from 67 to 78. Labour's defection would have left Olmert in control of only 59 seats.
Olmert's cabinet and the parliament need to approve Yisrael Beitenu's coalition membership but with Labour's support, he is certain to win ratification. A vote is likely to be held on Sunday.
Lieberman could be sworn in as a deputy prime minister, with special responsibility for strategic policy, as early as next week.
The ex-night club bouncer, an immigrant from the Soviet Union, would then be responsible for leading Israel's efforts to counter the potential nuclear threat from Iran.
In its statement, Olmert's office said the prime minister promised Peretz that his authority as defence minister would not be affected and there would be no change in the government's guidelines.
Lieberman would be in charge of
countering Iran's nuclear threat
Yisrael Beitenu's participation in the government would probably mean that Olmert's plan to dismantle dozens of Jewish settlements in the West Bank, while strengthening others, remains on the shelf.
Israeli Arab MPs have continued their criticism of the appointment and called for an international boycott of Israel should Lieberman join the cabinet.
"Labour's hypocrisy and flattery tried to legitimise Lieberman's entry," Ahmed Tibi, chairman of the Raam-Taal party, told AFP news agency. "It is a hypocritical party which wants to keep hold of its seats in government.
"Lieberman's entry is a blatant message that the government is legitimising racism and fascism and turning it into the mainstream of Israeli society," he said.
Javier Solana, the European Union's foreign policy chief, began a visit to Israel on Wednesday with a tense exchange with the latest addition to Olmert's government, saying he was meeting a man "I have disagreed with my entire life".
"Now that he is a member of the government, I would like to see the position he has," Solana said.
Lieberman quickly interjected, urging the European envoy to give him a chance.