Those aged between 16 and 30 who have lived in the US for five years could now be eligible for work permits.
The move is seen as addressing a key Latino concern in an election year.
But Mr Obama's Republican opponent, Mitt Romney, said it was the wrong way to approach the problem.
Mr Romney said the issue should be dealt with by legislation, rather than an executive order "that can be reversed by subsequent presidents".
The plan, which goes into effect immediately, is expected to affect as many as 800,000 people.
Mr Obama and his Republican opponent Mitt Romney are courting Hispanic voters in key states ahead of November's election.
Speaking at the White House, Mr Obama said the initiative was "the right thing to do", adding that "it makes no sense to expel talented young people" from the US.
The president also said the measure had been announced in "the absence of any immigration action" from Congress and urged the passage of the Dream Act, a bill that aimed to establish a path towards US citizenship for young people who were brought to the US as minors.
"They are American in their hearts, in their minds, in every way but one: on paper," Mr Obama said.
He said the measure would improve the US economy, benefit its national security and was simply "the right thing to do. Period".
In an unusual turn of events, Mr Obama was interrupted by a questioner from the media during his announcement, an intervention which left the president visibly surprised.
Earlier on Friday Secretary of Homeland Security Janet Napolitano said deportation laws were not designed to be "blindly enforced without consideration given to the individual circumstances of each case".
"Discretion, which is used in so many other areas, is especially justified here," she added.
The policy change does not provide a path to permanent lawful status, or a path to citizenship, Ms Napolitano said, adding that it is not immunity or amnesty.
But, she added, many "productive young people" who would be eligible under the changes posed no threat to national security or public safety.
In order to be eligible under the new initiative, illegal immigrants must:
have arrived in the US when they were under the age of 16
have lived continuously in the US for at least five years
be in school, or have graduated from high school or be honourably discharged veterans of the US military
have no criminal record
be under 30 years old.
If successful, applicants would receive a work permit for two years that can be renewed an unlimited number of times.
Mr Romney said Mr Obama's decision had complicated an issue that could only be dealt with through legislation.
"I believe the status of young people who come here through no fault of their own is an important matter to be considered and it should be solved on a long-term basis so they know what their future will be in this country," Mr Romney said.
"I think the action that the president took today makes it more difficult to reach that long-term solution," he added.
He did not say, however, whether he would reverse the decision if elected.
Latino rights groups in the US quickly hailed the decision, with the National Council of La Raza, the country's largest Hispanic organisation describing it as sensible, good news.
Source: BBC News
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