A statement released by the World Organisation for Human Rights (WOHR) USA said Yahoo had decided to settle the case following fierce criticism at a US congressional hearing last week.
Shi Tao, a business journalist, and Wang Xiaoning, a pro-democracy blogger, are serving jail sentences of 10 year each.
According to their families' lawsuit, which was backed by WOHR, their imprisonment was a direct result of information provided by Yahoo to Chinese authorities.
"We are committed to making sure our actions match our values around the world"
Yahoo has previously defended its actions, saying it had to comply with Chinese laws in order to operate in the country.
Shi was jailed in 2004 for divulging state secrets after he forwarded a Chinese government order forbidding journalists from marking the anniversary of the 1989 Tiananmen Square crackdown.
Police identified him using information provided by Yahoo.
Wang was jailed two years earlier after he was linked to emails and political essays posted online via information provided by Yahoo.
The two cases have grown into a public relations nightmare for Yahoo, led by a strong backlash against the company from human rights groups.
Last week, Yahoo founder and CEO Jerry Yang was lambasted by members of the US congress who accused the company of collaborating with an oppressive government and putting profit ahead of its moral obligations.
|Journalist Shi Tao was arrested and jailed for |
10 years by Chinese authorities [AP]
"While technologically and financially you are giants, morally you are pygmies," Tom Lantos, chairman of the House of Representatives Foreign Affairs Committee, told Yang at a hearing.
Yang and Michael Callahan, Yahoo's general counsel, apologised to Shi's mother and met other family members at the same hearing.
"After meeting with the families, it was clear to me what we had to do to make this right for them, for Yahoo and for the future," Yang, who emigrated from Taiwan as a boy, said in a statement on Tuesday.
"We are committed to making sure our actions match our values around the world.''
He said Yahoo was establishing a "human rights fund to provide humanitarian and legal aid to dissidents who have been imprisoned for expressing their views online".
China is the world's second largest internet market and companies such as Yahoo have been eager to secure their presence in the fast-growing sector.
Yahoo has not said whether it would change its dealings in China as a result of the settlement.