The move, announced late on Thursday, came a day after Microsoft said it would revamp its next-generation Windows operating system to make it easier for rival companies' products to compete.
New Mexico's withdrawal may provide the impetus for more out-of-court deals.
Analysts said Microsoft was now trying hard to divide the coalition of states opposing it.
Strategic move
"It is a very interesting strategic move by Microsoft to... try to... break up the state coalition by offering to settle," said Andy Gavil, a law professor at Howard University.
"It suggests that Microsoft has got a strategy afoot to try to placate the states by offering to pay attorney's fees."
But Iowa's attorney general, a leader in the fight, said he would press on with the case.
"We have the resources and the will to proceed" without New Mexico, Iowa Attorney General Tom Miller said.
First withdrawal since 1998
Under the settlement with New Mexico, Microsoft will pay the state's legal costs, and New Mexico will share in the effects of any eventual ruling in the case.
It became the first state to withdraw from the action since South Carolina in 1998.
Ms Madrid said she was "encouraged" by Microsoft's concessions, and described them as "a very good first step".
"My job is to do what I think best serves the interests of New Mexico consumers and businesses," she added. "I don't see the upside for having my state expending resources in a case of this magnitude," she said.
A Microsoft spokesman said that the company "was pleased to have this matter resolved".
The US Department of Justice declined to comment on New Mexico's decision.
Change in desktop
Wednesday's decision by Microsoft should mark an end to the practice of requiring computer manufacturers to display its products such as Internet Explorer on the desktops - or display screen - of new computers.
"So we are providing computer manufacturers with greater flexibility", and doing so immediately, it said.
The move is a 180-degree reversal from previous mandates by Microsoft. In the past, personal-computer (PC) makers, such as Compaq, Dell and Gateway were required to install programs such as Microsoft's Internet Explorer internet browser on computers alongside its ubiquitous Windows operating system.
But some analysts, such as Jonathan Geurkink of Ragen McKenzie in Seattle, said the change was largely cosmetic.
"On the public relations front it helps them in the sense that it shows them being deferential to the court," he told the Associated Press news agency.
But he said he saw little benefit for users or competitors.