"Starting with the next term, women will have the right to run in municipal elections and to choose candidates, according to Islamic principles," he said in speech to the Shura Council carried live on state television on Sunday.
Manal al-Sharif, a 32-year-old computer security consultant who was arrested on May 22 and detained for 10 days after posting on YouTube a video of herself driving around the eastern city of Khobar, said the king's decision was "a historic and courageous one".
"The king is a reformist," she said of the 86-year-old monarch, whose country was spared a wave of protests rocking the region by which autocratic regimes in Tunisia and Egypt were toppled.
Sharif was the icon of a campaign through which a group of defiant Saudi women got behind the steering wheels of their cars on June 17 in response to calls for nationwide action against a ban on driving.
Abdullah's move was also hailed by the United States and Britain, which both called it a significant "step forward" for the Saudi people.
"The announcements made today represent an important step forward in expanding the rights of women in Saudi Arabia, and we support King Abdullah and the people of Saudi Arabia as they undertake these and other reforms," White House National Security Council spokesman Tommy Vietor said.
Foreign Secretary William Hague said he welcomed the announcement and that "we look forward to examining the full details of the proposed changes and how they will work in practise".
The king's decision means women will be able to take part in the elections that are to be held in four years, as the next vote is due to take place on Thursday and nominations are already closed.
In addition to participating in the only public polls in the country, women would have the right to join the all-appointed Shura (consultative) Council, he said in the address opening the assembly's new term.
"We have decided that women will participate in the Shura Council as members starting the next term," the king said in the unexpected move to enfranchise women.
More than 5000 men will compete in Thursday's municipal elections, only the second in Saudi Arabia's history, to fill half the seats in the kingdom's 285 municipal councils. The other half are appointed by the government.
The first elections were held in 2005, but the government extended the existing council's term for two years.
King Abdullah said his decision came because "we refuse marginalising women's role in the Saudi society in all fields" and followed "consultations with several scholars".
He did not mention anything about women's right to drive in the kingdom where they must hire male chauffeurs, or depend on the goodwill of relatives if they do not have the means.
However, he said "balanced modernisation which agrees with our Islamic values is a necessary demand in an epoch where there is no place for those who are hesitant" in moving forward.