Al-Sadr's order came after he called on Arab states to support his militia's battle against "US occupation".
At least 270 people have reportedly died since an Iraqi military crackdown in Basra sparked fighting across the country.
The government welcomed Al-Sadr's decision, which followed intense negotiations involving al-Sadr himself, Al Jazeera understands.
Two Shia legislators also reportedly travelled to Iran to ask religious authorities there to intervene.
Nuri al-Maliki, Iraq's prime minister, called al-Sadr's statement "a step in the right direction".
Al-Maliki had personally supervised the operation in Basra against the militia groups.
Ali al-Dabbagh, an Iraqi government spokesman, said al-Sadr's order would help restore peace.
"A large number of people will listen to Muqtada al-Sadr's call. Life will return to all of Iraq as before," al-Dabbagh said on Al-Iraqiya state television.
But he also warned that "those who do not obey the instructions of the government and of Sadr, the government will be forced to implement the law against them".
He later told the Reuters news agency that despite al-Sadr's order, Iraqi troops would continue military operations against "criminals" in Basra.
"The operation in Basra will continue and will not stop until it achieves its goals. It is not targeting the Sadrists but criminals," he said.
Operation to continue
A curfew in Baghdad was lifted in most parts of the city at 6am (03:00 GMT) on Monday, permitting civilians to go out for the first time since Thursday.
But restrictions remained in place in three predominantly Shia neighbourhoods, including Sadr City.
James Bays, Al Jazeera's correspondent in Baghdad, said on Monday that although people were venturing out onto the streets they were nervous that fighting would flare up again.
The crackdown in Basra, which began on Tuesday, was aimed at disarming the city's warring Shia militias, including the al-Mahdi Army, as well as crushing a number of criminal gangs.
Al-Sadr's nine-point plan, agreed with the Iraqi government, was issued by his headquarters in the city of Najaf and broadcast through loudspeakers on Shia mosques.
Bays said the main elements of the plan were that al-Sadr's al-Mahdi Army forces should leave the streets in return for the Iraqi government's guarantee that it would not arrest Mahdi Army fighters unless they have arrest warrants for them.
The big question now was whether the fighters would obey the command because there are all sorts of factions and splinter groups in existence, he said.
Fighting continued in the Basra area after the announcement on Sunday.
Seven people also were killed when a mortar struck a residential district in Baghdad's Karradah district.
Witnesses reported clashes in the Shula area in a northern section of the capital.
The US military said it killed 25 suspected fighters in an air raid after American ground forces came under heavy fire in predominantly Shia eastern Baghdad, where the fiercest clashes in the capital have occurred.
Another 16 "criminals" were also killed by US forces in a series of incidents, half of those in northeast Baghdad, US military statements said.
Police in Basra said on Sunday that 163 people have been killed and about 500 injured in sporadic clashes in the city between government forces and militias since Tuesday.
|The fighting has severely disrupted the lives of |
Iraqi civilians in Sadr City [AFP]
In the southern city of Nasiriyah, 67 people have been killed and another 137 wounded, local officials said.
At least 10 mortars fell into Baghdad's fortified Green Zone as sporadic fighting continued overnight into Sunday.
British forces closed in on Basra on Sunday, but a spokesman said there were no plans yet to retake Iraq's second city.
Witnesses said British troops in armoured vehicles were manning checkpoints south of Basra and seen searching any cars heading into the city.
The British defence secretary was due to announce a further reduction in troops in Iraq but it is unclear now whether that will go ahead.
Tom Holloway, a British military spokesman, told Al Jazeera that British forces in Basra had fired artillery rounds at people they had identified as opposition fighters.
"We've been firing in support of Iraqi ground forces. They've been in contact, they've requested support from the coalition and artillery on a couple of occasions has been deemed the most appropriate response."
"We use our surveillance assets and conduct a collateral damage assessment. Obviously, once we've positively identified the target we make an assessment that we are able to attack it," he said.
Holloway said that British involvement in the operation is "entirely in line with the agreements with the government of Iraq", known as operational overwatch.
In a separate development, two US troops died in separate bombings in Iraq, the US military announced on Monday.
A soldier died when his vehicle was hit on Sunday by a roadside bomb in northern Baghdad, according to one military statement.
Another statement said that a Marine was "by an enemy force with an improvised explosive device" in western Anbar province on Saturday.