It will also transfer the bodies of nearly 200 Lebanese and Palestinians killed in recent years.
In exchange, the Shiite movement will hand over to Israel two soldiers it captured in a cross-border raid in July 2006 that sparked a 34-day war in Lebanon that killed 1,200 Lebanese and 160 Israelis.
Israel still does not know whether the soldiers -- Ehud Goldwasser and Eldad Regev -- are dead or alive, but they are widely assumed to be dead.
One view is that the deal could undermine Israel's deterrence of the Syrian- and Iranian-backed Hezbollah and the Palestinian Islamist movement Hamas, which is also holding an Israeli soldier it captured in June 2006.
"This is a very serious strategic mistake by the government," said Ely Karmon, a terrorism expert at the Herzliya Interdisciplinary Centre.
"The mere fact that we are heading for a deal without knowing whether (Regev and Goldwasser) are alive or dead, and are releasing murderers, is a major failure," he told AFP.
While Prime Minister Ehud Olmert has said that as far as he knows the two soldiers are dead, Hezbollah has refused to divulge any information on their fate.
And the heads of Israel's Mossad spy agency and the Shin Beth internal security services both oppose the deal, which they say marks a "dangerous precedent" by swapping live people for bodies, a senior government official said.
But the government has repeatedly said the deal -- the eighth struck with Hezbollah since 1991 -- reflects a moral obligation to citizens and soldiers.
"As Israel's defence minister and a former chief of staff and commander, I again say that we have a moral obligation to bring Ehud Goldwasser and Eldad Regev home," Ehud Barak said on Monday.
The last major swap was in 2004, when Israel released more than 400 prisoners in exchange for an Israeli businessman abducted by Hezbollah and the bodies of three soldiers.
But Karmon said "the deal is presented in Lebanon as a triumph for Hezbollah and it weakens Israel's image in Lebanon. Israel should decide how to act in order not to have to pay a higher price each time."
Israel went to war in 2006 partly in order to free Regev and Goldwasser.
Its failure to do so stirred up a painful and heated debate over the price tag for securing the release of the two reserve servicemen.
One of the most controversial aspects of the deal for many in Israel is the release of Kantar, a Lebanese militant who brutally killed Danny Haran, his daughter Einat and a policeman in a 1979 raid on northern Israel.
The murders in the coastal town of Nahariya shocked Israel to the core by its brutality. Kantar and co-militants shot dead Danny, 28, and crushed the four-year-old girl's skull with rifle butts.
Another point of contention is that the swap deal required that Hezbollah provide a report on the fate of Israeli airman Ron Arad, missing since his plane was shot down over Lebanon in 1986.
Yet the report failed to shed any new light on Arad's fate, underscoring Israel's dilemma.
"The report on Ron Arad, as Hezbollah presented it, does not provide clear answers and does not solve the question of his fate," Barak said on Monday.
Eitan Haber, an adviser to the late prime minister Yitzhak Rabin, put a positive spin on the deal.
He said Israel's willingness to release murderers in exchange for bodies is a sign of strength, though its enemies will still try to abduct Israelis.
"We will probably have more such incidents in the future. Our enemies know we will pay a much higher price than required... but our soldiers know that we have the higher moral ground," Haber told AFP.
"The swap will under no circumstances weaken Israel's deterrence against Hezbollah. But they will continue to kidnap our soldiers and we will keep paying.
"There is no such thing as 'worth it or not' in prisoner exchanges. Bodies are not worth a thing but the feeling it gives the leaders, the families and the soldiers that know they will always return home is priceless."
