The agreement includes an "out of court settlement" of $115 million to be paid to compensate copyright holders, said a US spokesman for Australia-based Sharman Networks, which owns Kazaa.
A source familiar with the deal said that the funds "would be distributed among the various claimants," which include the global record labels and Hollywood studios.
The settlement ends litigation in the United States and Australia, and promises to crack down on what industry officials said was one of the world's biggest illegal "peer to peer" (P2P) file-sharing operations.
Sharman Networks said that it "clears the way to enable distribution of the broadest range of licensed content over Kazaa."
Company chief executive Nikki Hemming said that the settlement "marks the dawn of a new age of cooperation between P2P technology and content industries."
"All the parties involved now recognize the time is right to work together, and we are looking forward to collaborating with the music and motion picture companies to make P2P an integral part of the future of online digital entertainment."
Kazaa, which had an estimated 4.2 million users at its peak in 2003, was accused by the music industry and major Hollywood studios of being a major source of illegal copies of works distributed over the Internet.
The deal comes a year after the US Supreme Court ruled that Grokster and other P2P sites may be held liable for copyright infringement if they encourage people to make unauthorized copies of songs, films, or other content. This opened the door for the music industry to pursue damages.
The Federal Court of Australia last year found the Kazaa operators guilty of authorizing widespread copyright infringement.
Kazaa has agreed to introduce "filtering technologies ensuring that its users can no longer distribute copyright-infringing files," according to a statement by the London-based International Federation of Recording Industries, representing global music labels.
Industry officials said that the move marks a major step in moving consumers away from illegal music-swapping to legal purchases of online content though sites like Apple's iTunes and the reborn Napster, a former swapping Website that also converted to a legal model.
"This is welcome news for the music community and the legal online music marketplace," said Recording Industry Association of America chairman Mitch Bainwol. "Steadily but surely, we are passing another important marker on the remarkable journey that is the continuing transformation and development of the digital marketplace.
"The winners are fans, artists, and labels and everyone else involved in making music, and our partners in the technology community."
Although some surveys show that many consumers around the globe still make illegal copies from file-sharing sites, observers said that the shift by Kazaa is a major development.
"Kazaa has been a thorn in the side of the music and motion-picture industry for years," said Eric Bangeman, a columnist for the technology Website Ars Technica. "At one point, the company claimed to be responsible for almost 80 percent of worldwide file-sharing," he said.
"While that number may be debatable, the fact remains that Kazaa and parent company Sharman Networks have been public enemy number one for the entertainment industry since shortly after its inception."
© 2006 Agence France-Presse
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