The Department of Industrial Policy and Promotion (DIPP) issued a circular making changes in the Consolidated FDI Policy to allow investments from the neighbouring country.
"The government of India has reviewed the policy and decided to permit a citizen of Pakistan or an entity incorporated in Pakistan to make investments in India, under the government route, in sectors/activities other than defence, space and atomic energy," said an official notification issued by the DIPP.
Pakistani investments are allowed with immediate effect, it said.
All investment proposals must be routed through the Indian government.
The clearance of Pakistani investments has created a positive tone for the forthcoming visit of External Affairs Minister SM Krishna to Islamabad in September, and comes despite the lack of adequate action by Pakistan against the 26/11 terrorists.
Pakistan was the only country in the negative list under the Foreign Exchange Management Act (FEMA), which forbids investing in India. Sri Lanka was removed from the list in 2006, and Bangladesh in 2007.
The decision to allow foreign investments from Pakistan follows a road-map chalked out by trade and industry ministers of India and Pakistan in April.
The two neighbours, who have fought three wars over territorial claims in Jammu and Kashmir and continue to differ on terror, have been following a new strategy to put economic relations at the forefront of their relations in the hope of creating a conducive atmosphere for resolving contentious issues.
The latest Indian decision reinforces Pakistan's wish to grant this country the status of 'Most Favoured Nation', setting the stage for improved economic engagement between the two countries.