The Home Office will be split into two separate departments for security and for justice in the next six weeks.
John Reid will have overall responsibility for counter-terrorism
The Department for Constitutional Affairs will take control of probation, prisons and prevention of re-offending and be renamed the Ministry of Justice.
The slimmed-down Home Office will then be left to concentrate on dealing with terrorism, security and immigration.
Tories say it will "compound" problems, while ex-home secretary Charles Clarke called it an "irresponsible decision".
John Reid's slimmed-down Home Office will absorb counter-terrorism strategy from the Cabinet Office, with the creation of an Office for Security and Counter-Terrorism.
Mr Reid said the changes were needed to meet the changing threats to focus "towards the challenges of today's world, and focus on the priorities of today's people".
He told MPs that, although Lord Falconer would remain as head of the DCA during the reorganisation, he would not be secretary of state for justice - saying that it would be a role for an MP rather than a peer.
In a written statement to the House of Commons, Prime Minister Tony Blair said Britain's counter-terrorism capabilities were "the best in the world" but still needed to be improved, with these changes designed to provide a "step change".
He was "strengthening" the home secretary's role to give him the lead responsibility for dealing with threats to the UK "including their overseas dimension".
HOME OFFICE SPLIT
Two ministries instead of one
Home Office to refocus on security, policing, counter-terrorism, immigration, borders and ID cards
Ministry of justice for courts, prisons, sentencing policy, probation
However, other ministers, including the Foreign Secretary, Defence Secretary and the Secretary of State for Communities and Local Government, would still have responsibilities with a national security committee, chaired by the prime minister, bringing all key figures together once a month.
The changes come after a year in which the Home Office has been besieged by crises, with Mr Reid famously saying the department was "not fit for purpose" when he took up the job.
However there was opposition to the planned split from Mr Reid's predecessor, Charles Clarke, who said the problem with the department was "a lack of co-ordination between its various elements".
He called the split an "irresponsible decision [which] further delays the reforms which are critically necessary throughout the criminal justice system".
He said "the coherence and coordination of the criminal justice system which is so important for its success will be damaged seriously by these proposals".
The Conservatives also oppose the split, saying it could cause more problems.
Shadow home secretary David Davis said: "The logic, presumably, is that this job is too difficult for the home secretary to do.
"It has been well run in the past by home secretaries of all parties, when it was much bigger and still had responsibility for licensing, gambling, broadcasting, fire, civil defence, human rights, equal opportunities and charities.
"Breaking it up will solve none of the Home Office's problems. It will just create a whole new raft of problems."
He said that rather than having one department unfit for purpose, the danger was now that there would be two.
For the Lib Dems Nick Clegg noted that his calls for a full inquiry into the 7 July bombings had been rejected on the grounds it would distract officials from their anti-terror work.
The decision to split the department would take up more time and effort than that, he suggested.