London said it stopped and seized the vessel because it was carrying Iranian oil to Syria in violation of EU sanctions.
Gibraltar Chief Minister Fabian Picardo said his government was allowing the vessel to set sail after talks with Iranian officials, who assured him the cargo would not be transported to Syria.
"In light of the assurances we have received, there are no longer any reasonable grounds for the continued legal detention of the Grace 1 in order to ensure compliance with the EU Sanctions Regulation," Picardo said in a statement.
Gibraltar's Supreme Court had been due to decide Thursday on whether Grace 1 could continue to be held. It was anticipated that the ship would be freed, because the court order allowing its detainment was due to lapse and the government had not said that it would seek an extension.
But the proceedings took a twist when the US Department of Justice made a request to seize the ship.
In an interview with CNN, Picardo said the appeal from Washington came too late to factor into Thursday's decision to release the Grace 1, but that Gibraltar was still studying it.
He suggested that it was possible for the vessel to be re-seized before it left Gibraltar's waters.
"We are looking at the request from the United States and making an independent assessment of that, which has not been done in time for the hearing today, but which could of course come at any time before the vessel sails," he said.
The US Justice Department has not publicly commented on why it wanted to seize the Grace 1.
The capture of the ship escalated tensions between London and Tehran, which later seized the British-flagged Stena Impero in the Strait of Hormuz, a strategically important shipping route in the Gulf region.
The Stena Impero remains held by Iran, which also seized the Panama-flagged MT Riah in mid-July in the strait.
The British Foreign Office defended the country's actions on the Grace 1, saying: "We will not stand by and allow Iran – or anyone – to bypass vital EU sanctions on a regime that has deployed chemical weapons against its own people."
It also said Britain's action off Gibraltar was very different than Iran's activity in the Gulf.
"There is no comparison or linkage between Iran’s unacceptable and illegal seizure of, and attacks on, commercial shipping vessels in the Strait of Hormuz and the enforcement of EU Syria sanctions by the Government of Gibraltar," the Foreign Office said in a statement.
Hamid Baeidinejad, the Iranian ambassador to Britain, said the Grace 1 would soon leave Gibraltar. He tweeted that Gibraltar's rejection of the Justice Department's request was a "humiliating defeat" for the US.
Iranian Foreign Minister Mohammed Javad Zarif accused the US of attempting "to abuse the legal system to steal our property on the high seas."
"This piracy attempt is indicative of Trump admin's contempt for the law," he tweeted.
The United States has a major stake in the naval spat: It has launched a "maximum pressure" campaign against Iran in the wake of its exit from the 2015 nuclear accord and has reimposed tough economic sanctions.
The crisis began to escalate in May and June when the US accused Iran of attacks on tankers, though Tehran denies involvement. The subsequent flurry of military run-ins and seized cargo ships has stoked fears of a new conflict in the Middle East.
Washington is putting together a coalition of countries that would offer military escorts to commercial ships in the Gulf. The Pentagon has also announced the deployment of additional troops and military assets in the region.
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