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The announcement - given in a written answer in the Commons - ends a 15-year cover-up.
Mrs Thatcher revealed he had confessed to the authorities in 1964 but under a secret deal was granted immunity from prosecution.
Minutes after the Prime Minister's statement Buckingham Palace said he was being stripped of his knighthood.
The news comes after renewed speculation about Professor Blunt's role in the defection in 1951 of spies Guy Burgess and Donald Maclean, prompted by a new book The Climate of Treason.
Professor Blunt has gone into hiding. He is believed to have fled the country and gone to somewhere in southern Europe.
Ministers admitted the professor's lawyer had been warned in advance about the prime minister's statement - although he was not told exactly what it would say.
He had been part of a Cambridge spy ring made up of Guy Burgess, Donald Maclean, and Harold "Kim" Philby - who was in charge of British intelligence's anti-communist counter-espionage from 1944-46.
Burgess and Maclean defected in 1951 following a tip-off from Philby. He defected himself in 1963.
Professor Blunt became a Marxist under the influence of his Cambridge friend Guy Burgess.
In World War II he served as an officer in MI5 between 1940 and 1945. The authorities were aware of his Marxist views but did not consider him to be a security risk.
Professor Blunt's name emerged during investigations into the defection of Burgess and Maclean. He was interviewed 11 times but did not confess.
In 1964 new information came to light which implicated Blunt in the Cambridge spy ring. The Attorney General decided the only way to get to the truth of the affair was to persuade Blunt to confess by offering him immunity from prosecution.
He admitted he had become an agent of Russian intelligence and talent-spotted for them at Cambridge in the 1930s.
While with MI5 he used his old contacts in the Russian intelligence service to assist in the arrangements for Burgess and Macleans' defection.
During this time Blunt was allowed to remain art adviser to the Queen. The security services did not want to risk losing his co-operation by forcing him to resign.
Andrew Boyle, author of the book The Climate of Treason, published ten days ago, said he had known Professor Blunt was the fourth man for three years.
The following day it was revealed Professor Blunt had not left Britain - as widely reported at the time - although he had gone into hiding.
A friend and former student of the spy, Brian Sewell, told the media Professor Blunt was "appalled" by Mrs Thatcher's statement.
Professor Blunt made his own statement to the media on 20 November in which he claimed the decision to grant him immunity from prosecution was taken by the then prime minister, Sir Alec Douglas-Home.
He said he had come to "bitterly regret" his spying activities, but, at the time, he had done so out of idealism.
He died in disgrace three years later.
It is thought some former colleagues from MI5 were angry that he continued to enjoy such a privileged life despite his treachery and they set out to expose him.
They leaked details of his spying career to the author Andrew Boyle who then wrote a book, in which Professor Blunt's character was thinly disguised as someone called Maurice.
Rumour persisted about a "fifth man" in the ring. He was named in 1990 by a KGB defector as John Cairncross.
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