Trade has long been tied to political issues between the hostile neighbours, who have fought three wars since independence from Britain in 1947.
There are hopes that progress in trade ties will help bolster a fragile peace process, which the two resumed in February, with political implications likely to outweigh any practical benefits.
"This was a decision taken in the national interest and all stakeholders, including our military and defence institutions, were on board," Information Minister Firdos Ashiq Awan told reporters.
Pakistan's military, which has ruled Pakistan for more than half of its history, sets security and foreign policy.
Critics say Pakistan's generals have been so obsessed with a perceived security threat from India for decades that their judgment on vital issues such as the economy has become clouded.
Islamabad has been looking increasingly isolated after India signed a wide-ranging agreement with Afghanistan last month, and the unilateral US raid that killed Osama bin Laden in Pakistan in May which heavily strained ties with ally Washington.
"I think they have realised they can't have bad relations with the United States and at the same time continue to have very poor relations with India because this synergy will be very dangerous for Pakistan."
Islamabad wants a major say in shaping any peace settlement in Afghanistan, where India is taking an active but low-profile approach to building influence through aid and investment.
But Islamabad has alienated both the Washington and Kabul governments -- who will play a central role in any reconciliation -- because of its suspected links with militant groups fighting Western and Afghan forces in Afghanistan.
The United States is likely to applaud Pakistan's decision to give India MFN status.
Peace across the heavily militarised frontier between India and Pakistan is crucial for the United States to draw down troops and stabilise Afghanistan without sparking off a proxy war between New Delhi and Islamabad in that country.
Awan said commerce officials from the two countries would meet in India in mid-November to discuss ways to boost trade.
India broke off talks after the November 2008 attack on Mumbai by Pakistan-based militants that killed 166 people.
While India granted Pakistan MFN status in 1996, Pakistan hesitated.
Pakistani officials want New Delhi to remove non-trade barriers against Pakistan goods. Pakistan has long complained that Indian quality standards and customs procedures have hindered the flow of Pakistani goods into India.
Of the USD 1.4 billion in trade recorded in 2009/10, Indian exports to Pakistan stood at USD 1.2 billion while Pakistan exports to India totalled USD 268 million, according to official data.
The wider economic disparity is just as stark. Pakistan reported 2.4 percent growth in gross domestic product in the 20100-11 fiscal year while India reported 8.5 percent growth.
Since the 1960s, when Pakistan was an Asian tiger economy and India a basket case, India's economy has swelled to USD 1.06 trillion, more than eight times the size of Pakistan's USD 207 billion.
Trade ties were severed after the second war between the two countries in 1965 and have yet to recover fully.
But despite the challenges, the two now appear more keen to remove barriers to trade and the two countries' commerce ministries say trade could easily triple in three years.
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