Gaza-based Hamas and President Mahmoud Abbas's Palestine Liberation Organisation have agreed to implement a unity pact, both sides announced in a joint news conference.
The move envisions forming a unity government within five weeks and holding national elections six months after a vote of confidence by the Palestinian parliament.
Palestinians have long hoped for a healing of the political rift between the PLO and Hamas, which won a Palestinian election in 2006 and seized control of Gaza from forces loyal to Western-backed Mr Abbas in 2007.
But Arab-brokered unity pacts reached between the two sides have yet to be implemented, leaving many Palestinians sceptical about their leaders' reconciliation pledges.
"This is the good news we tell our people: the era of division is over," Hamas prime minister Ismail Haniyeh told Palestinian reporters to loud applause.
Hamas has repeatedly battled Israel, which it refuses to recognise.
Mr Abbas said the pact did not contradict peace talks he is pursuing with Israel.
He said that an independent state living peacefully alongside Israel remained his goal.
Before the announcement, Israeli Prime Minister Benjamin Netanyahu cautioned Mr Abbas over the unity efforts, saying he had to choose between peace with Israel or Hamas.
Mr Abbas's Fatah party has remained in control of the Palestinian Authority in the occupied West Bank and pursued troubled peace talks with Israel, which are set to expire on 29 April.
An Israeli air force jet struck northern Gaza wounding six people, one seriously, Hamas said shortly after the announcement.
The raid came as thousands took to the streets of Gaza City to celebrate the agreement to form a unity government to end seven years of divided administration.
Israel has cancelled a planned session of peace negotiations with the Palestinians.
In a statement, Mr Netanyahu's office said: "Israel has cancelled a negotiations meeting that was expected to be held this evening."
It did not provide further details.
The United States said it was disappointed by the unity pact and said it could seriously complicate peace efforts.
"The timing was troubling and we were certainly disappointed in the announcement," State Department spokeswoman Jen Psaki told a regular news briefing.
"This could seriously complicate our efforts. Not just our efforts but the efforts of the parties to extend their negotiations."