Gordon Brown and Iraqi prime minister Nouri Maliki say UK forces will have "completed their tasks" and leave the country by the end of July next year.
The two leaders' joint statement came as they held talks in Baghdad before Mr Brown headed to Basra.
The UK PM praised British forces for making Iraq a "better place".
There are currently about 4,100 UK troops in Basra, southern Iraq. Between 200 to 300 military advisers are likely to remain after combat troops leave.
Mr Brown will make a statement to the House of Commons on UK troop deployment in Iraq on Thursday.
'New era'
The withdrawal announcement comes after at least 18 people were killed and dozens wounded in a twin bomb attack in Baghdad on Wednesday.
BBC diplomatic correspondent Paul Adams said the announcement ended months of speculation.
At a press conference, Mr Brown said: "We have agreed today that the mission will end no later than 31 May next year.
"Our troops will be coming home within the next two months [after that]."
Mr Maliki confirmed that the agreement included a provision for the Iraqi government to request an extension of the British military presence.
However, both leaders indicated it was not expected to be used.
Mr Brown said: "We have made a huge contribution and of course given people an economic stake in the future of Iraq. We leave Iraq a better place."
He added: "I am proud of the contribution British forces have made. They are the pride of Britain and the best in the world."
In their joint statement, the leaders said the role played by the UK combat forces was "drawing to a close".
The partnership between the two countries would "continue to take on new dimensions and will be strengthened through cooperation in all areas", they added.
Timing questioned
The withdrawal of UK troops is expected to start in the spring.
In Basra Mr Brown visited British troops and laid a wreath in memory of the 178 British servicemen and women who have been killed in Iraq since the 2003 invasion.
 Gordon Brown paid tribute to servicemen and women who have died |
Responding to the announcement, Shadow defence secretary Liam Fox said it showed "renewed confidence" in the Iraqi government's ability to maintain security on its own.
But he questioned the timing of the announcement: "The government's policy hitherto has always been to say that they would be coming out, in the near future, when circumstances allowed on the ground.
"I don't know why the government would have changed their mind and given such a specific commitment to dates.
"I'm sure that it's complete coincidence that it's done on the same day that we've got horrendous unemployment figures."
The Conservatives, the UK's official opposition, have reiterated their calls for a public inquiry into the causes and conduct of the Iraq war.
At prime minister's questions, shadow foreign secretary William Hague said: "The government has delayed for years the establishment of an inquiry and now the learning of lessons that may be relevant to Afghanistan and elsewhere can no longer be delayed."
Harriet Harman, standing in for Mr Brown at PMQs, replied: "We have made clear that while our troops are still in Iraq, which they are, doing their duties, that we will not have a full inquiry on how they went in until after they return.
"We have to respect the fact that our fighting forces are still in Iraq. There is no delay."
Nick Clegg, the leader of the UK's third largest party the Liberal Democrats, said: "After five long years in which the enormity of our forces' courage and sacrifice has been matched only by the enormity of the government's mistake, it is a huge relief that the end is at last in sight.
"There must be a fully independent public inquiry into how this was allowed to happen. The time when Brown has been able to hide behind our troops' ongoing presence in the country is coming to an end.
"The death and injury of hundreds of British troops and hundreds of thousands of Iraqi civilians in this futile war cannot simply be swept under the carpet."
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