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The Israeli Chief Justice, Meir Shamgar, said the decision was taken on the basis of reasonable doubt over the accusation that Mr Demjanjuk was Ivan the Terrible, a gas chamber operative at the death camp Treblinka, in Poland.
Mr Shamgar was careful to avoid declaring him "innocent", however, saying there was ample evidence that Mr Demjanjuk served as a guard in other camps.
He revealed that the judges had agonised over the decision to set free a man they believed to be guilty of Nazi atrocities.
"It is difficult to sit in judgement in a trial pertaining to the Holocaust," he said. "Judges are not devoid of feelings ... But it is incumbent upon us to contain those feelings."
Demjanjuk, a 73-year-old retired car worker from Ohio, was sentenced to death five years ago for running the gas chamber at Treblinka, where more than 870,000 Jews were murdered. He has always maintained he was the victim of mistaken identity.
His case was reviewed after evidence turned up last year in KGB archives including statements by Treblinka guards identifying "Ivan the Terrible" as Ivan Marchenko, not Ivan Demjanjuk.
Josef Czarny, a survivor of Treblinka who gave evidence at the original trial, wept openly when he heard the news.
"It is a big shock," he said. "The judges are wrong, he is the criminal."
Mr Demjanjuk left the court to return to jail for his own protection until he can leave Israel.
Before the ruling, he had told reporters: "I want to see my wife, my children, my grandchildren. I want to go home."
Mr Demjanjuk was stripped of his US citizenship in 1981 and deported to Israel for trial on war crimes charges in 1986.
He has lodged an appeal against the removal of his US citizenship in the light of today's ruling, but for now he is expected to travel to the Ukraine, his birthplace and the only country which has indicated it will accept him.
The Demjanjuk case was only the second Nazi war crimes trial to be held in Israel, the first being the trial and subsequent execution in 1961 of Adolf Eichmann.
John Demjanjuk never went to the Ukraine, because a US appeals court ruled he could return home while his original 1986 deportation was reviewed.
He left Israel for the United States in September 1993, and regained his US citizenship in 1998.
The US government, however, resumed its attempts to strip him of his citizenship the following year.
In 2000, Demjanjuk sued for damages of $5 million, saying the government's pursuit of the case amounted to mental torture. The lawsuit was dismissed.
His citizenship was again revoked in 2002. A judge ruled that even if Demjanjuk were not Ivan the Terrible, there was enough evidence to prove he had been a death camp guard.
Demjanjuk appealed again, but was unsuccessful.
Legal hearings to deport him from America are still ongoing.
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