The Government is scrapping the public sector pay cap which has limited rises to a maximum of 1% for the past seven years.
The announcement came as ministers approved an average 1.7% rise for prison officers and improvements for police pay totalling 2% for 2017/18.
From 2018/19, the Government will be ready to show "flexibility" in areas where there is evidence of problems with recruitment, retention and skills shortages, said Prime Minister Theresa May's official spokesman.
Asked whether the introduction of flexibility in pay settlements meant that the cap was over, the spokesman said: "The answer is yes."
The move on the pay cap comes after intense pressure from unions and the Labour Party for an end to the period of restraint which saw a two-year freeze when the Conservative-led coalition government came to power, followed by the 1% cap starting in 2013.
At a meeting of Cabinet chaired by Mrs May in 10 Downing Street, ministers approved a pay body recommendation of 1.7% average rises for prison officers for 2017/18 in order to tackle shortages of staff and expertise.
Police will receive a 1% hike in basic pay along with a 1% non-consolidated increase for 2017/18 - a one-year lump sum which will not necessarily be continued in future years.
The 2017/18 awards will be funded from existing departmental budgets.
Mrs May's spokesman said: "Cabinet agreed that public sector workers are among the most talented and hard-working people in our society. They, like everyone else, deserve to have fulfilling jobs that are properly rewarded."
Looking ahead to the next round of pay settlements, which will begin when the Treasury sends out the remit for public sector pay review bodies for 2018/19 at the time of the autumn Budget, the spokesman said: "There will still be a need for pay discipline over coming years to ensure the affordability of public services and the sustainability of public sector employment.
"However, the Government recognises that in some parts of the public sector, particularly in areas of skill shortage, more flexibility may be required to deliver world-class public services, including in return for improvements to public sector productivity."
He added: "The Government takes a balanced approach to public spending, dealing with our debts to keep our economy strong while also making sure we invest in our public services.
"Government will continue to ensure that the overall package for public sector workers recognises the vital contribution we make and ensures we can deliver world-class public services, while also being affordable within the public finances and fair to taxpayers as a whole."
The pay offer for prison offers and police was branded "pathetic" by the TUC, which pointed out that it remains well below the current inflation rate of 2.9%.
TUC general secretary Frances O'Grady said: " This below-inflation pay offer is pathetic.
"Public sector workers have suffered seven long years of real pay cuts, and are thousands of pounds worse off.
"Today's announcement means bills will continue to rise faster than their wages.
"If ministers think a derisory rise like this will deal with the staffing crisis in our public services, they are sorely mistaken."
Steve White, chairman of the Police Federation of England and Wales, warned the announcement will leave many officers "angry and deflated".
He said: "Police officers do not join the service to make huge amounts of money, they do it out of a sense of duty and this year in particular have been tested to the max.
"However, they expect to be paid suitably for the immensely demanding role they perform and this simply is not the case."
The Federation had asked for a 2.8% uplift to basic pay.
"We were not greedy in what we asked for," Mr White added. "Officers have been taking home about 15% less than they were seven years ago.
"While it is a step in the right direction, the Government should have done this sooner but we don't feel that non-consolidated pay awards are the way forward."
Liberal Democrat leader Sir Vince Cable said: "It is good to see the Government finally recognise that the public sector pay cap is no longer sustainable.
"The cap must now be lifted across the board so all public sector workers are given the pay rise they deserve."
Chief Secretary to the Treasury Liz Truss told BBC Radio Four's World at One: "What we have done with all of the pay review body recommendations for 2017/18, is we have absolutely listened to what those pay bodies have said and responded accordingly.
"And it was particularly the prison service pay review body that made a recommendation because of the issues about recruiting prison officers and making sure we retain those really important public sector workers in our prisons that we have agreed to their recommendations.
"What we are talking about now is the approach for 2018/19.
"We have now worked over the summer looking at the issues, where are the pinch points within the public services, and we have decided to give those pay review bodies and those departments greater flexibility to address the issues we face."
Ms Truss added: "In the case of prison officers, they have looked at the issues and they have recommended a slightly higher amount in that case.
"We are making sure that our policy is targeted to where there are specific issues. Where we need to make sure we recruit more talent into the public sector. But, also, where we do need to make sure that we are holding on to those really valued people.
"What we are making sure is that we look at it on a workforce by workforce basis because there are very different issues for teachers, than for nurses, and for police officers."
Tory MP and former health minister Dan Poulter told the BBC: "What I'd like to see is the Government beginning to listen to the independent pay review bodies and allowing them to have a free hand and genuine independence, not being told they have to limit public sector pay increases to 1%.
"And seven years of pay restraint is too long. And it's about retention and recruitment of staff and recognising the cost of living is rising and we need to see across-the-board lifting of that public sector pay cap."