Guterres was convicted of launching attacks that left at least 1,000 people dead.
East Timor independence
The violence is said to have occurred after East Timor voted in a UN-sponsored referendum to break away from 24-years of Indonesian rule.
After intense international pressure, Indonesia indicted Guterres and 17 other suspects, mostly military and police officers.
All 18 suspects have been set free.
Joko Sarwoko, the supreme judge, said that Guterres "was not proven to have structural command to co-ordinate attacks, even if he was the leader of the militia, so he could not be held responsible or the violence".
According to Sarwoko, another factor that contributed to the overturning of Guterres' conviction was that his militia was formed by the request of the then-governor of East Timor, who himself was freed on appeal in 2004.
Guterres is expected to be released within days.
The acquittal has angered human rights groups who have previously called for the establishment of an international tribunal to try those responsible for the violence.
However, in 2005, Indonesia and East Timor formed a joint "truth commission" to investigate the violence and promote reconciliation.
It is due to present its findings later this year.
The commission has heard testimony from military officers and victims, but has no power to prosecute individuals or order anyone to testify.
It could recommend amnesties to people found to have committed major crimes.
The UN is boycotting the commission because of the amnesty provision.
East Timorese and international human rights advocates have labelled it a "facade".
Leaders in Dili have not publicly called for more trials or an international tribunal. This is reportedly to avoid upsetting Indonesia, which is a key trading partner.