In a pamphlet published by the Social Market Foundation think tank, Mr Lilley argues the law on cannabis use is "unenforceable and indefensible".
Drug pressure groups have welcomed the comments but the government dismissed them saying it would maintain the ban on cannabis.
Mr Lilley is the most senior politician to come out in favour of legalising the drug, although former Cabinet Office Minister Mo Mowlam has called for it to be decriminalised.
He told BBC News: "We are forcing cannabis users into the arms of hard drugs pushers. It is that link I wish to break."
The Conservative Party needed to reach out to young people and those from ethnic minorities, who came up against this law and knew it was "ridiculous".
Widdecombe's warning
Those on the authoritarian wing of the party have already moved to oppose his ideas.
Shadow home secretary Ann Widdecombe warned: "I would myself wonder what we expect the big drug barons to do if we legalise cannabis.
"I think it's very unlikely that they would go home.
"It's far more likely that they would put a huge amount of their effort into marketing hard drugs and probably targeting ever younger age groups."
Rethink
Under Mr Lilley's proposals, magistrates could licence outlets selling cannabis to over-18s.
There would be limits on the amount sold and the drug would be taxed and carry a health warning.
Cultivation for personal use would be permitted.
Mr Lilley is not the only Tory MP who is seeking to review the party's position on drugs.
Speaking on BBC 1's Question Time, shadow chancellor Michael Portillo said the Tories had to be prepared to engage in a debate about calls for the
legalisation of cannabis.
Saying the arguments on both sides were finely balanced, Mr Portillo continued: "We should be the party that is open to new thinking... yes, we would consider this question."
Mr Lilley is calling on the other leadership contenders to make it known where they stand on decriminalisation of cannabis.
Not authoritarian monsters
Another leadership hopeful, Iain Duncan Smith, said on Question Time: "Let's not immediately leap to conclusions that those who do not want to liberalise it are monsters of authoritarian nature.
"They are just people who want to protect their families and worry as we all do."
Michael Ancram, Ken Clarke and David Davis said they too currently opposed legalisation but were willing to have a debate on the issue.
Mr Clarke told BBC News on Friday "an alternative, slightly druggie lifestyle" had emerged from relaxing cannabis law in Amsterdam and Kingston, Jamaica, which he did not want to see in Britain.
Many of the same dealers currently selling drugs illegally would sell legalised cannabis, said Mr Clarke, who argued more people could be led onto hard drugs.
He dismissed the suggestion the issue could cause a split in the party.
Charity support
Drugs charity Release welcomed Mr Lilley's comments, saying the debate on cannabis has come on "in leaps and bounds" in recent months.
The prime minister's official spokesman said on Friday: "Cannabis is dangerous, it does cause medical problems, cancer, hallucinations - therefore the position has not changed."
He added: "People are perfectly at liberty to express their views. The government is aware that there is a debate going on. But the government has made its position very clear."