The action Thursday was a stunning reversal for one of the signature cases brought by special counsel Robert Mueller.
It comes even though prosecutors for the past three years have maintained that Flynn lied to the FBI in a January 2017 interview about his conversations with the Russian ambassador.
Flynn admitted as much, pleading guilty before later asking to withdraw the plea, and he became a key cooperator for Mueller as the special counsel investigated ties between Russia and Trump's 2016 political campaign.
Thursday's action was swiftly embraced by Trump, who has relentlessly tweeted about the "outrageous" case and last week pronounced Flynn "exonerated," and it is likely to energize supporters of the president who have taken up the retired Army lieutenant general as a cause.
Trump praised Attorney General William Barr for abandoning the prosecution of Flynn.
"Bill Barr is a man of unbelievable credibility and courage and he's going to go down on the history books," Trump told "Fox & Friends" on Friday.
Trump said that if Barr had been his first attorney general, there would never have been a Russia probe.
"He would have stopped it immediately," Trump said.Democrats, however, have complained that Barr is excessively loyal to the president.
"Attorney General Barr's politicization of justice knows no bounds," House Speaker Nancy Pelosi said. She accused Barr's department of "dropping the case to continue to cover up for the president."
Shortly before the filing was submitted, Brandon Van Grack, a Mueller team member and veteran prosecutor on the case, withdrew from the prosecution, a possible sign of disagreement with the decision.
After the Flynn announcement, Trump declared that his former aide had been "an innocent man" all along. He accused Obama administration officials of targeting Flynn and said, "I hope that a big price is going to be paid."
Going further, he said of the effort to investigate Flynn: "It's treason. It's treason."
In court documents filed Thursday, the Justice Department said that after reviewing newly disclosed information and other materials, it agreed with Flynn's lawyers that his interview with the FBI should never have taken place because his contacts with the Russian ambassador were "entirely appropriate."
The US attorney reviewing the Flynn case, Jeff Jensen, formally recommended dropping it to Barr last week, the course of action publicly recommended by Trump, who appointed Barr to head the Justice Department.
Barr has increasingly challenged the federal Trump-Russia investigation, saying in an interview last month that it was started "without any basis."
In February, he overruled a decision by prosecutors in the case of Roger Stone, a longtime Trump friend and adviser, in favour of a more lenient recommended sentence.
Jensen said in a statement that he "briefed Attorney General Barr on my findings, advised him on these conclusions, and he agreed."
The department's action comes amid an internal review into the handling of the case and an aggressive effort by Flynn's lawyers to challenge the basis for the prosecution.
The lawyers cited newly disclosed FBI emails and notes last week to allege that Flynn was improperly trapped into lying when agents interviewed him days after Trump's inauguration.
None of the documents appeared to undercut the central allegation that Flynn had misled the FBI.
In recent months, Flynn's attorneys have levelled allegations about the FBI's actions and asked to withdraw his guilty plea.
A judge has rejected most of the claims and not ruled on others, including the bid to revoke the plea.
Earlier this year, Barr appointed Jensen, the top federal prosecutor in St. Louis, to investigate the handling of Flynn's case.
As part of that process, the Justice Department gave Flynn's attorneys internal FBI correspondence, including one handwritten note from a senior FBI official that mapped out internal deliberations about the purpose of the Flynn interview: "What's our goal? Truth/admission or to get him to lie, so we can prosecute him or get him fired?" Other documents show the FBI had been prepared before its interview to drop its investigation into whether he was acting at the direction of Russia.
Later that month, though, as the White House insisted that Flynn hadn't discussed sanctions with Russian Ambassador Sergey Kislyak, FBI officials grew increasingly concerned by Flynn's conversations with the diplomat and kept the investigation open to question him about that.
Two agents visited him at the White House on January 24, 2017.
But Thursday's filing, signed by US Attorney Tim Shea, says the FBI had no basis to continue investigating Flynn after failing to find illegality.
It says there was nothing on his Russia calls "to indicate an inappropriate relationship between Mr Flynn and a foreign power." (AP) RUP