The United States has recognised the Libyan opposition as the country's "legitimate governing authority".
The move means billions of dollars of Libyan assets frozen in US banks could be released to the rebels.
The decision was announced by US Secretary of State Hillary Clinton at a diplomatic meeting in Istanbul.
Western and Arab members of the Libya Contact Group are drawing up a plan to end hostilities, which will be presented to Col Muammar Gaddafi.
"The United States views the Gaddafi regime as no longer having any legitimate authority in Libya," Mrs Clinton said.
"And so I am announcing today that, until an interim authority is in place, the United States will recognise the TNC [Transitional National Council] as the legitimate governing authority for Libya, and we will deal with it on that basis."
She added: "The TNC has offered important assurances today, including the promise to pursue a process of democratic reform that is inclusive both geographically and politically."
The TNC said it "expressed its gratitude and respect to the people of the United States", which it called "the protector and promoter of democracy and freedom across the world".
In Istanbul, other foreign ministers said the whole contact group - including more than 30 Western and Arab countries - agreed to recognise the rebels.
Many of them have already individually recognised the TNC.
Italy's Foreign Minister Franco Frattini said the decision left Col Gaddafi "no other option" but to leave power.
However, Col Gaddafi swiftly rejected the move.
Addressing a televised rally in the town of Zlitan, he said: "Trample on those recognitions, trample them under your feet... They are worthless."
Entrenched in Tripoli
Mr Frattini said the UN special envoy to Libya, Abdul Elah al-Khatib, would take the contact group's ceasefire proposals to the Libyan leadership, and negotiate on their behalf.
A statement released by the group said Col Gaddafi "must leave power according to defined steps to be publicly announced," and called for "the formation of an interim government to ensure a smooth and peaceful transition of power".
The meeting was also expected to explore measures to increase the pressure on the Libyan regime, such as constraining government broadcasting. It was also to look at a report on the TNC's plans for progress to democracy.
Representatives of the Benghazi-based TNC were at the meeting, but invitations to China and Russia were both declined.
The conflict in Libya appears to be in a protracted stalemate. Rebels are holding eastern Libya and pockets in the west.
Col Gaddafi remains entrenched in the capital Tripoli, despite a Nato bombing campaign of more than 6,000 sorties against regime forces.
International sanctions have also been imposed and international arrest warrants issued against leading figures in the Libyan regime.
In Tripoli, Col Gaddafi's government has been holding crisis talks over the supply of fuel to the country.