The deal, brokered by the EU, capped six months of delicate negotiations and marks a milestone for the region's recovery from the collapse of Yugoslavia in the 1990s.
If implemented, it could unlock Serbia's potential as the largest market in the former Yugoslavia, taking the country from international pariah under late strongman Slobodan Milosevic to the threshold of mainstream Europe.
"And the white smoke is out! Habemus pactum! Happy:)))" Kosovo's EU's integration minister, Vlora Citaku, tweeted after the prime ministers of both sides initialed a two-page plan outlining an end to the ethnic partition of Kosovo between its Albanian majority and a small, Belgrade-backed pocket of some 50,000 Serbs in the north.
The schism has dogged regional stability and development since Kosovo seceded from Serbia in 2008.
The Kosovo Serbs will almost certainly resist in a region bristling with weapons and deep animosity, and were already demanding a referendum on the deal.
In exchange for limited autonomous powers for the Serb north, Serbia agreed not to block Kosovo's path to eventual membership of the EU - a concession Kosovo hailed as recognition of independence.
"This agreement is de-jure, legal recognition by Serbia, which will open the way for Kosovo to join international organizations," Kosovo Prime Minister Hashim Thaci, who led a guerrilla insurgency against Milosevic's forces in 1998-99, told reporters.
Serbia says it will never recognize as sovereign a territory it considers the cradle of the Serb nation.
But Friday's deal reflects a sea change in official policy and a realization in Serbia that it has been swimming against the tide at the expense of its economy.
Neighboring Croatia, a wartime foe of Serbia during Yugoslavia's demise, joins the EU on July 1, a sobering reminder for many Serbs of just how far they have fallen behind.
Kosovo is recognized by over 90 countries, including the United States and 22 members of the 27-nation EU that Serbia wants to join. But it has yet to join the United Nations, something Serbian ally and U.N. veto-holder Russia holds the key to.