Selvarasa Pathmanathan, who was arrested in August 2009, was no longer in detention and was free to carry out work for a charity he had formed, said Lakshman Hulugalle, the head of the defence ministry's media centre.
The announcement comes less than a month after the closure of the last camps which had housed people who were displaced by the 37-year conflict and amid pressure on the government to pursue reconciliation with minority Tamils.
But the main Tamil political party said the release should not be seen as an act of reconciliation, asserting that Pathmanathan -- who is also known as "KP" -- had cut a deal with the government.
The news emerged when Hulugalle was asked how Pathmanathan, who has an Interpol arrest warrant initiated by India against him, was reportedly living in the island's north.
India regards the 58-year-old Pathmanathan as a key suspect in the May 1991 assassination of Gandhi by a Sri Lankan Tamil suicide bomber during an election rally in the southern