Israel has apologised for the spy scandal and has promised it will take steps to ensure no similar incident happens again.
Prime Minister Helen Clark today said she was pleased New Zealand and Israel would now be able to resume friendly diplomatic relations.
The relationship has been frosty since Israel refused to apologise for what Miss Clark described as "utterly unacceptable" behaviour surrounding two alleged Mossad agents, Uriel Zoshe Kelman and Eli Cara, who were arrested in March 2004 and charged with trying to fraudulently obtain New Zealand passports.
They were convicted in July last year, then deported last September after serving two months of their six-month prison sentences.
Miss Clark imposed diplomatic sanctions pending an apology from Israel, including delaying approval for the appointment of a new Israeli ambassador.
In addition, she postponed foreign ministry consultations and Israeli officials who wanted to visit New Zealand had to apply for visas.
The strained relationship meant Israeli President Moshe Katsav was not invited to extend a visit to include New Zealand when he was in Australia in February.
However, President Katsav said on Australian television at the time that he was sorry relations had been harmed by the spy scandal and Miss Clark took that as an encouraging sign that a satisfactory apology would be forthcoming.
In a brief letter dated today, Israeli Foreign Minister Silvan Shalom said Israel attached great importance to its relationship with New Zealand and he was pleased to reiterate its desire to continue to develop and enhance this relationship in the future.
"In this context, we wish to express our regret for the activities which resulted in the arrest and conviction of two Israeli citizens in New Zealand on criminal charges and apologise for the involvement of Israeli citizens in such activities.
"Israel commits itself to taking steps to prevent a recurrence of similar incidents in the future," Mr Shalom said.
While Mr Shalom did not say in his three-paragraph letter that the two men were spies, Miss Clark said the Government had strong grounds for believing they were working on behalf of an Israeli intelligence agency.
Miss Clark said the apology meant restrictions on official contact with Israel were being lifted today.
The new Israeli ambassador could now be accredited, and visits and other diplomatic activities could be restored.
She said official inquiries had revealed that a very small number of New Zealand passports had been obtained by those working on behalf of Israeli intelligence.
Those passports had been cancelled. Attempts to use them would be futile, Miss Clark said.
"Israel's formal apology and undertaking to prevent the recurrence of the activities that resulted in the arrest and criminal convictions of two Israeli citizens in New Zealand is welcome," she said.
In a letter in response, Foreign Affairs Minister Phil Goff thanked Mr Shalom for his letter and said that because of the apology and assurances it contained, New Zealand now regarded the matter as being behind it.
Mr Goff said the two countries should "move forward" and resume friendly diplomatic relations.