Pakistan is to be re-admitted to the Commonwealth, five years after it was suspended because of a military coup.
Mr Musharraf has pledged to give up his army post
The Commonwealth Ministerial Action Group praised progress towards democracy by President Pervez Musharraf, who seized power in 1999.
But it said after its meeting in London that it would keep its eye on "continuing concerns".
Diplomats said the UK and Australia wanted to reward President Musharraf for helping fight al-Qaeda.
Pakistan is seen as a key ally in the US-led war on terror.
The Commonwealth Secretary General, Don McKinnon, announced its re-admittance at a news conference on Saturday.
He said the nine-member Commonwealth Ministerial Action Group welcomed steps being
taken by Pakistan, but said it had "continuing concerns in regard to the strengthening of the democratic process" and would keep monitoring its progress.
He said it expected President Musharraf to stand down as head of the army by the end of this year, as he has promised.
The decision was endorsed by the new government in Pakistan's old enemy India.
Pakistan welcomed the move.
Information Minister Sheikh Rashid said: "It is the right decision at the right time. We have fulfilled all the requirements and it's a wise decision."
The country was suspended from the 53-nation group's
decision-making councils after Gen
Musharraf ousted the elected prime minister Nawaz Sharif in a bloodless coup.
The president held elections in October 2002, and has appointed a prime minister to run the country day-to-day.
But his attempts to be readmitted before now have failed because parliament rejected his changes to the constitution.
The BBC's world affairs correspondent David Loyn said the decision came despite Pakistan's chequered democratic record.
President Musharraf has successfully excluded from the country the leaders of both of Pakistan's main political parties, Benazir Bhutto and Nawaz Sharif.
There has also been condemnation of the jailing of a senior opposition leader, Makhdoom Javed Hashmi.
The US State Department has said that the prospects for democracy in Pakistan remain poor.
Also on Saturday, the Commonwealth agreed to take Fiji off its watch list, commending it for democratic progress since its own coup four years ago.
Mr McKinnon said he had been asked to monitor the situation, while helping the country of 868,500 to "strengthen democratic processes and institutions".