The country's main land distributor has three months to change its policy of selling property only to Jews.
Still, supporters of the Jewish National Fund (JNF) insist it has the right to refuse to market its lands to Arabs.
The case points up a basic contradiction Israel has been grappling with for decades - maintaining its Jewish character while offering equality to its Arab minority in the framework of a democratic regime.
The venerable Jewish group in effect acknowledged before the court that it can no longer eliminate Israeli Arabs from its land transactions, agreeing to reinstitute a complex land-for-land deal to try to keep everyone happy.
"I think part of this is redefining the vision of what the JNF is all about," said Mike Nitzan, a member of the JNF board.
The JNF is a century-old symbol of the drive to reclaim the Holy Land and fill it with Jews. Founded in 1901, the JNF is known around the Jewish world for its little blue collection boxes, where Jews contributed money to buy land for settlement.
A century later, the JNF is still in the business of providing land for Jewish settlement in Israel, owning about 13 percent of the land in the country.
But even some Jewish critics say it has outlived its usefulness in a modern, democratic state that grants equal rights to non-Jewish minority citizens. Legal expert Moshe Hanegbi told Israel Radio that the JNF should have been phased out when the state of Israel was created in 1948.
Under the deal accepted Monday by the Israeli court, while the JNF would agree to sell lands to Arabs, but the Israel Lands Authority (ILA) would give the JNF an equal amount of land in exchange. That would allow the JNF to tell its contributors that it still maintains its original function of providing land for Jews in Israel. The court ordered the JNF to come up with a permanent solution in three months.
Critics charged the deal still discriminates against Israel's Arabs, who make up about 20 percent of the population.
"The JNF's policy could create a total separation between Arabs and Jews in where they live," said Auni Bana, a lawyer with one of the petitioners, the Association for Civil Rights in Israel. "This is racism."
On the other side, die-hard JNF donors insisted they won't let the organization back down. Israeli Nobel laureate Robert Aumann and former military chief Moshe Yaalon said they want to join the court case on the side of the JNF.
"The good Jews who donated money 60, 50, 40 years ago, and even today didn't do so to sell land to Arabs," Aumann told Israel Radio on Monday.
The case has been in the courts since 2004, when the ILA abandoned the land-swap arrangement with the JNF, and the organization in turn stopped marketing lands to Arabs.
Attorney General Menachem Mazuz has ruled that the JNF must allow non-Jews to buy its land, following the offering of a tender in northern Israel in which Arabs were not allowed to bid.