The landmark ruling, 15 years in the making, centered around the question of "who is Jewish" and is seen as an important victory for the Reform and Conservative movements.
"If the state of Israel claims to be the nation-state of the Jewish world, then the state of Israel must recognize all the denominations of Judaism and imbue them with equality and respect," said Rabbi Gilad Kariv, head of the Reform movement in Israel and a candidate with the liberal Labor Party in upcoming parliamentary elections.
Israel's powerful ultra-Orthodox establishment has held a virtual monopoly on religious matters for Israeli Jews, overseeing life-cycle rituals like weddings and burials and using their political clout to gain influence over matters like immigration.
Monday's ruling chipped away at that power by saying that the state must allow Jews who undergo conversions with the liberal movements in Israel to receive citizenship.
"Jews who during their stay in Israel were legally converted in a Reform or Conservative community must be recognized as Jews," the court said.
It added that the ruling only applied to the question of citizenship, and did not delve into religious affairs.
Israel previously recognised conversions by the liberal streams conducted overseas. This ruling now applies to conversions inside Israel.
The ruling does not resolve the issues faced by people who qualify for citizenship under the so-called Law of Return but are not considered Jewish under religious law.
The Law of Return grants citizenship to anyone with at least one Jewish grandparent, while religious law requires one to have a Jewish mother. These different definitions have allowed tens of thousands of people, mostly from the Soviet Union, to immigrate to Israel.
Monday's ruling only directly affects about 30 people a year, such as spouses of Israeli citizens, advocates say. But both supporters and opponents of the decision suggested there was much deeper symbolism.
"Whoever becomes Jewish in a Reform conversion or something similar is not Jewish," said David Lau, one of Israel's two chief rabbis.
"No ruling by the Supreme Court this way or that way will change this fact."
This ruling flies in the face of Palestinian refugees living outside of Israel.
The UN General Assembly passed Resolution 194 in 1947 stating that "Palestinian refugees wishing to return to their homes and live in peace with their neighbours should be permitted to do so at the earliest practicable date."
Israel does not recognise this Right of Return.
Since its creation in 1948 in what was historic Palestine, Israel has sought to attract Jewish settlers from all around the world, including Europe before and after the Nazi Holocaust.
The most recent waves of Jewish migration came from Russia following the collapse of the Soviet Union, and Ethiopia.
At the same time, Israel has pursued a policy of expulsion and marginalisation of the Palestinian native population, beginning with the Nakba, which saw more than 700,000 Palestinians driven out of their homes as a result of the violence that accompanies the creation of Israel.
To date, Israel does not allow millions of Palestinian refugees and their descendants within historic Palestine and outside to return to their lands, despite repeated UN Security Council resolutions upholding their right of return, while encouraging Jewish migration and settlement in the occupied Palestinian territories in violation of international law.
Agencies contributed to this report.