Alberta Court of Appeal Justice Myra Bielby said there was no clear evidence that releasing Khadr would cause irreparable harm.
He is expected to be released within the next couple of hours.
"I look forward to Omar Khadr letting the Canadian public see who he is," said Edmonton lawyer Denis Edney, who represents the 28-year-old.
"Today is a wonderful day for justice, it's a start."
Some of those in the courtroom to hear the judge's decision today clapped and others cried after Bielby announced her ruling.
After the decision was revealed, Edney said he told Khadr: "I said we've done it, that's what I said."
"I imagine he'll be trying to understand whether this is really true and he will not really believe it until he gets picked up by me," Edney said.
Court of Queen's Bench Justice June Ross had granted Khadr bail last month, but the federal government appealed that decision.
Bielby heard arguments on Tuesday from Khadr's lawyers and a federal prosecutor seeking an emergency stay of the lower court ruling.
Khadr will have to continue seeing a psychologist and will live with his lawyer, Dennis Edney, under a curfew from 10 p.m. to 7 a.m.
Edney said his wife has been cleaning their home for weeks and has bought clothes for Khadr in anticipation of his arrival at their home.
"She has every intention of giving him a good family meal," he said, adding he's not sure whether Khadr will be spending the night in his home tonight.
Interaction with his own family can only be made by telephone or video conference, and the conversations will have to be in English, and be supervised.
Any face-to-face visits with his family can only happen with prior written approval from a supervisor.
Khadr is also prohibited from any communication with members of a terrorist group. He cannot apply for a passport, and his internet access will be limited and monitored.
Federal government 'disappointed'
"We are disappointed with today's decision, and regret that a convicted terrorist has been allowed back into Canadian society without having served his full sentence," said a statement from Public Safety Minister Steven Blaney's office.
"Omar Khadr pleaded guilty to heinous crimes, including the murder of American army medic Sgt. Christopher Speer."
Edney was quick to criticize the Harper government's handling of the Khadr case challenging the government to show him where he's wrong in his assessment of Khadr.
"My view is very clear," said Edney, "Mr. Harper is a bigot. Mr. Harper does not like Muslims."