In a 10 - 3 vote the court Friday dismissed the government case against the chief justice.
Iftakhar Chaudhry's lawyer Munir Malik called the verdict "an historic" decision.
He says Friday we saw the birth of a new Supreme Court, one fully committed to judicial independence.
Hundreds of lawyers and anti-government activists rallied outside the Supreme Court and cheered the decision as soon as it was announced.
In a written statement, Prime Minister Shaukat Aziz said the government would accept the verdict "with grace and dignity."
President Musharraf suspended Chaudhry in March after accusing him of abusing his authority.
The judge's supporters claimed the suspension was a blatantly unconstitutional attack on the court's integrity.
The controversial move sparked massive, nationwide protests against the government.
Chaudhry's courtroom victory is widely seen as a stunning rebuke to President Musharraf's authority.
The ruling comes as the Pakistani leader is already reeling from a wave of suicide attacks in recent days.
More than 150 people have been killed as militants respond to last week's government raid of Islamabad's pro-Taleban Red Mosque.
Political experts here in Pakistan say the president faces his greatest political challenge since seizing power through a military coup in 1999.
Analyst Farzana Bari says, ironically, Friday's ruling could be good news for the embattled president.
"Under the circumstances I don't think it will be a setback," said Bari. "He is in deep trouble right now and this may give him a little bit of relief."
She says that win or lose at least one of the president's major battles is now behind him and he can try to move on to the next fight.
Mr. Musharraf is pursuing a second five-year term in office later this year.
Nationwide elections are expected before January 1, but the president is seeking reappointment from the country's existing national assembly.
Opposition lawmakers say the president's plan would not only be undemocratic, but also unconstitutional and are vowing a legal challenge.
Government critics say the looming standoff may be the real reason behind Mr. Musharraf's efforts to dismiss the notoriously independent chief justice. Chaudry had also issued a series of rulings against the government including a demand for greater information about suspected Islamists who the government is believed to be holding.
True or false, the president is now facing a decidedly uncompromising Supreme Court, and a potentially uphill battle for re-election.