"It's a great day for democracy and rule of law and for the fundamental rights of the people of Pakistan. The Supreme Court has delivered justice," said Nadir Chaudhri, spokesman for Sharif, speaking in London.
A government minister said the court decision was right.
"They are part of the nation, part of Pakistan's politics and there should be no restriction on their returning and taking part in the general election," Railways Minister Sheikh Rashid Ahmed told Geo Television.
ELECTIONS DUE
Sharif was sentenced to life in prison on various charges after he was overthrown. He and his family later went to Saudi Arabia after the government said he had agreed to 10 years of exile.
But Sharif denied any such agreement with the government had been reached and filed a petition in the top court seeking to clear the way for the return of himself and his family.
A spokeswoman for Bhutto's Pakistan People's Party also welcomed the court ruling.
"We welcome the decision. He was twice elected prime minister and he is a leader in his own right," she said,
"All exiled prime ministers should be allowed to come back to Pakistan with dignity and the respect due to them."
Bhutto has been in negotiations with Musharraf on a power-sharing deal but Sharif has criticised her efforts and called on her to join efforts to bring an end to Musharraf's rule.
Political worry has hurt confidence on Pakistan's main stock market. The Karachi Stock Exchange benchmark index fell more than 3 percent on Thursday but recovered some ground late to end just over 2.5 percent down before the court ruling.
The index has lost almost 5.5 percent since the start of the week but is still 19.54 percent higher than it was at the start of the year.
