Ben Zygier, the so-called 'Prisoner X', was facing at least 10 years in prison for treason. He was found hanged in his isolation cell in Ayalon prison near Tel Aviv in December 2010.
"After negotiations, the two parties have reached an agreement whereby the state will pay USD 1.1 million to the deceased's family," the ministry said in a statement yesterday.
The family of Zygier, who held Israeli and Australian citizenships, had accused Israel of negligence in dealing with his case.
The justice ministry statement stressed that the deal with Zygier's family was not an "admission of alleged wrongdoing."
It was instead "to avoid the affair going to court, which would lead to the publication of numerous details of the case which could cause serious harm to national security."
The reasons for Zygier's detention were unclear, but the Australian Broadcasting Corporation said in a report in May that the 34-year-old, who was allegedly working for Israel's foreign spy service Mossad, had unwittingly sabotaged a top secret spy operation in Lebanon.
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