Al-Mahmoudi said Libya would buy British missiles and air defence systems, in what would be the largest British defence sale to the former outcast state since an international arms embargo on it ended in 2004.
Blair said on Tuesday: "We now have very strong co-operation on counter-terrorism and defence and a commercial relationship which, as you can see from this important investment deal, is one that is simply going from strength to strength."
Tripoli announced ahead of the premier's arrival that it would also sign a $900m exploration deal with British Petroleum (BP), which would mark the company's return to Libya after a 33-year absence.
Blair pointed to the deal "as an indication of the extent to which ties between the two countries have been transformed".
His office said the talks would focus on bilateral ties, the situation in Darfur and the fate of five Bulgarian nurses and a Palestinian doctor facing execution in Libya after being found guilty of deliberately infecting children at a hospital with the HIV virus.
Blair last visited the North African country in March 2004, three months after Tripoli's dramatic decision to renounce ambitions to acquire weapons of mass destruction.
"A few years back Britain and Libya could never have had this relationship. I could never have had this relationship with leader Gaddafi," Blair said.
"Now all of that has changed and it's a change to the benefit of Libya, to the benefit of Britain and the wider region," he added.
Speaking on his airliner before leaving London, Blair said Libya had a vital role to play in fighting the spread of extremism, and said Gaddafi had kept his pledges since returning to the international fold.
"Some of the information they have provided has been extremely valuable in combating terrorism," he said.
Blair's efforts to bring Gaddafi into the international fold in 2004 had caused discomfort in the UK, amid memories of the Lockerbie air disaster, when Libyan agents allegedly brought down a Pan Am airliner over Scotland in 1988, killing 270.
The decision to travel to Tripoli in 2004 and shake hands with Gaddafi in a desert tent was "highly controversial, but it was the right thing to do", Blair's official spokesman said on condition of anonymity.
"A few years back Britain and Libya could never have had this relationship"
Tony Blair, UK prime minister
Gaddafi has agreed to scrap his chemical weapons stockpile by the end of 2010. British experts are aiding the work and helping Libyan weapons scientists turn their expertise to radiological medicine, the foreign office said.
The British government has said it is aware of concerns about human rights in Libya and doubts over the systems of government and justice, but believes that it is crucial to continue developing ties, Blair's spokesman said.
Blair is likely to use the African tour, which will also include visits to Sierra Leone and South Africa, to gain support for greater pressure on Sudan over the Darfur conflict.
The departing prime minister, who leaves office on June 27, has been widely praised for strong leadership on Africa and for setting the agenda on debt relief and anti-poverty initiatives during his 10-year premiership.
However, after visiting the US and France this month, and with the G8 summit in Germany and a pending EU leaders' meeting in Brussels, opponents have criticised Blair for embarking on a lengthy "farewell tour."
Downing Street was keen to stress that far from a valedictory farewell, Blair's Africa visit comes at a "critical juncture," as G8 talks on climate change and world trade negotiations come to a head.