The policy change will mean up to 25 people per year can have the surgery for a total annual cost of about $1 million.
Health Minister Fred Horne said the government is reinstating the policy because it's simply the right thing to do.
"Alberta is a very progressive province and policy needs to catch up to where Albertans are," Horne said Thursday from Calgary. "I think this reflects a decision of a government that is very much in tune with Albertans and their views."
Horne would not say whether the Progressive Conservative caucus voted on the issue.
Former premier Ed Stelmach's government cut funding for the operations in April 2009. At the time, gay rights activists estimated there were about 600 people on a waiting list.
Kris Wells, a spokesman for the Institute for Sexual Minority Studies at the University of Alberta, called the new policy an historic victory that will save lives.
He said some people who couldn't have the operation considered killing themselves.
"It sent people's lives into chaos and turmoil. People ended up leaving the province. Other people contemplated suicide," he said. "They saw no hope and possibility for their lives without this medically necessary procedure."
Wells said the lesbian, gay, bisexual and transgender community is jubilant about the government's change of heart and credits Premier Alison Redford.
"This is a clear move toward strengthening human rights in this province," he said.
"We met with her before the provincial election and extensively laid out what our concerns and issues were with the government and she made a commitment to address them."
Wells said "dozens" of people filed complaints with Alberta's human rights commission over the 2009 cuts. He is hopeful they will now be quickly resolved.
Redford is to make welcoming remarks to Edmonton's LGBT community Saturday following the city's annual Gay Pride parade. It will be the first time an Alberta premier has been associated with the festival, which runs Friday through June 17.
Opposition Wildrose Leader Danielle Smith is also to make an appearance.
Smith said she does not support the government's new policy because it defies common sense. She called it a purely political move designed to divide Albertans.
"Lets face it, our health care system is in crisis. It cannot perform current medically necessary procedures in a timely way. It is incumbent on the government to solve those problems first before they talk about expanding care," Smith said from High River.
"There are all kinds of things that are not covered: dentistry, chiropractic, insulin pumps, or proper food for seniors in our long-term care facilities. Things that are way higher priority for Albertans than this kind of procedure."
Smith's party struggled with accusations of homophobia in the recent provincial election campaign, when a blog by candidate Allan Hunsperger surfaced saying homosexuals would burn in a lake of fire.
While Smith herself said she was pro-gay marriage, she defended Hunsperger's right to his religious beliefs.
Redford attacked Smith for her position, stating at the time that if Hunsperger was a Progressive Conservative, she would have removed him from her team.
Smith cited the incident as one of several missteps by her party in the dying days of the campaign that led to the Tories being re-elected.
Wells called the former Tory government's decision in 2009 to cancel funding for the operations punitive and spiteful. But he said the times are clearly changing.
"Rights for the LGBT community have been won in the courts. They were never freely given by the government of Alberta," he said.
"What we are now seeing is an evolution where rights are freely given and they are the rights that every citizen of this province enjoys, regardless of their differences."