Observers say that the man often described as the "bishop for the poor", is a virtual political novice, best known for his advocacy of land reform and calls to renegotiate an energy treaty with neighbouring Brazil.
Speaking to his supporters at his campaign headquarters, Mr Lugo said the result showed that little people could also win and that this was the Paraguay he had dreamt about - a country for everyone.
"I invite Paraguayans of all political types, even the ones who don't share our ideals, to help this country that was once great be great again," he told the cheering crowd.
Our correspondent says that jubilant supporters of Mr Lugo packed the streets of the capital, waving banners and singing songs, as it became clear not only that he had won, but that the victory would be respected.
Blanca Ovelar was the Colorado Party's first female candidate
Ms Ovelar, whose campaign to become the first woman president had suffered from internal party divisions, acknowledged defeat, and wished the country "a time of reconciliation" and "joint reconstruction".
Sitting President Nicanor Duarte hailed the democratic process: "For the first time in our history, one party will transfer power to another without a coup, without bloodshed and without fighting among brothers," he told a news conference.
Mr Lugo's victory brings to an end one of the longest periods of continuous rule by any party in the world - the Colorado Party has been in power since 1947.
"This is the first time in my life that I have witnessed a power change in my country and so has my mother in her 60s," Oliver, a resident of Asuncion, told the BBC news website. "Sixty-one years is too many for any party to remain in power."
The switch in power is also the latest in a series of election triumphs by leftist, or centre-left, leaders in South America.
But Mr Lugo has rejected accusations from Mr Duarte that he will follow the style of leftist leaders in Bolivia and Venezuela once in office.
Mr Duarte had warned that what he called agitators from Venezuela and Ecuador were trying to meddle in the poll.
Our correspondent says the celebrations will last well into the night in Asuncion, but there seems little doubt that the challenges facing the new president when he takes office in August will be enormous.
Inequality and corruption are persistent problems and poverty remains widespread, particularly in the rural areas, with many are forced to leave the country in search of work.
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