WASHINGTON — The Bush administration restored full diplomatic ties with Libya on Monday, rewarding a longtime foe for giving up terrorism and unconventional weapons, and tacitly encouraging Iran and other countries to follow suit.

Completing a reversal that began three years ago, administration officials said they would open an embassy in Tripoli and drop Libya from their list of nations that sponsor terrorism. David Welch, assistant secretary of State for the Middle East, said the announcement demonstrated that when countries "follow international norms, they will reap concrete benefits."

"Libya serves as an important model as we push for changes in policy by other countries, such as Iran and North Korea," Welch said.

U.S. officials hope the move will encourage Libya to further open its economy, including its underdeveloped oil industry, which is potentially one of the world's largest. Libya's oil reserves rank in the top 10 worldwide, but its production lags. After the administration lifted U.S. economic sanctions in 2004, American oil companies joined others doing business in Libya, and Libyan oil began arriving at U.S. refineries that year.

At a morning news conference, Welch denied that the move was driven by an interest in oil, but acknowledged that Libya's economy has not opened to Americans as much as hoped for since economic sanctions were lifted.

Libya "remains a problematic place to do business," he said. "We would appreciate greater openness, as would any number of potential foreign partners."

U.S. officials said the Libyan economy has many traditional rules — common to the region — that make it hard for foreigners to trade and invest. State Department travel warnings note that credit cards and checks tied to U.S. banks are usually not accepted in Libya, which remains mostly a cash economy. Officials said they hoped that better ties would give momentum to modernization and lead to an opening of the economy.

After Monday's announcement, analysts speculated that the Bush administration was eager to publicize the restoration of relations with Libya as a success story that showed, at a time of foreign policy frustrations in Iraq, Iran and elsewhere, that the United States can carry off diplomacy in the Middle East.

"The Bush administration has been looking for ways to show they can walk and chew gum, and solve problems in a sophisticated way, without resorting to bombing," said David Mack, a former senior State Department official who is now a vice president at the Middle East Institute in Washington.

The United States closed its embassy in Libya in 1980, at a time when U.S. officials viewed Libyan leader Moammar Kadafi as one of the most dangerous men in the Middle East. The U.S. held Libya responsible for a series of deadly terrorist attacks in the 1980s, including the bombing of Pan Am Flight 103 over Lockerbie, Scotland in 1988, in which 270 people died, mostly Americans.

President Reagan bombed Libya in 1986. The United Nations and the United States each imposed sanctions on Libya, and the U.S. sought to isolate it diplomatically.

In 1999, Libya began to give ground, surrendering two suspects for trial in the Lockerbie bombing. In December 2003, it took its biggest step, moving to dismantle its incipient unconventional weapons program and long-range ballistic missiles, leading to the breakthrough on sanctions in 2004.

Since then, the United States has held Libya out as a model of how countries with nuclear or chemical weapons programs should act. U.S. officials have also praised Libya for its cooperation in battling Al Qaeda and other terrorist groups, a message they repeated Monday.

The Bush administration, trying to build international pressure on Tehran to halt its nuclear program, is eager to show Iranians that they would be better off abandoning nuclear ambitions than defying other countries to build a nuclear arsenal, as North Korea has done.

Secretary of State Condoleezza Rice commended Libya in a statement for its "excellent cooperation" in fighting terrorism.

Yet U.S. officials moved slowly to restore diplomatic relations and end Libya's inclusion on the terrorist list. Mack, the former senior State Department official, speculated that the administration wanted to be sure that the unpredictable Kadafi would not change course in a way that could be deeply embarrassing to the White House.

Welch, in an interview, said U.S. officials wanted to be "very, very careful" before normalizing relations. He said they wanted Libya to fully own up to past behavior and promise not to repeat it.

"Given the long and difficult nature of this relationship, we wanted to be very scrupulous in asserting that they met those standards," he said.

The administration's move brought praise from some in Congress, which has 45 days to review the decision before it takes full effect.

Rep. Tom Lantos, (D-Burlingame), the senior Democrat on the House International Relations Committee, said that through Monday's actions, "the United States dramatically demonstrates to the remaining rogue states — and particularly to Iran — that our country takes note of positive changes in behavior and is more than willing to reciprocate."

Rep. Peter Hoekstra (R-Mich.), chairman of the House Intelligence Committee, welcomed the move "as a means to expand U.S.-Libyan collaboration against humanity's common enemy, terrorism."

But some of the relatives of those killed in the Lockerbie crash voiced outrage, while others were concerned about the fate of a complex legal agreement. Under a settlement with relatives of the victims of Pan Am Flight 103, Libya has paid each family $8 million and is scheduled to pay $2 million more once it has been removed from the U.S. terrorism list.

Skeptics of the administration's latest steps include human rights activists, who said the United States was making a mistake by striking a deal with Kadafi.

"It is unfortunate that the restoration of full diplomatic relations occurred while my brother, Fathi … remained in jail," Mohamed Eljahmi said in a statement.

Fathi Eljahmi is a former provincial governor and democracy activist who was imprisoned in 2002 for slandering Kadafi.

Welch, the assistant secretary of State, said the Eljahmi case was "troubling." He said the U.S. government continued to have concerns about Libya's human rights records, but hoped that closer ties would give the United States more leverage.

One issue that stood in the way of Monday's normalization was an allegation that Libya was involved in an assassination attempt against Saudi Arabia's King Abdullah in 2003, when he was crown prince. But last September, the two countries announced that they had resolved the issue and restored diplomatic ties.

Another issue is Libya's seven-year imprisonment of Palestinian and Bulgarian medical personnel on charges that they infected Libyan children with HIV, the virus that causes AIDS. U.S. officials believe that there is no merit to the charges and that Libya may drop them.