Araibi, 25, a former Bahraini national youth team player, was granted refugee status in Australia after fleeing charges in the oil-rich kingdom connected to Arab Spring protests.
But he was stopped at Bangkok's main airport at Bahrain's request on 27 November as he arrived in Thailand for his honeymoon.
He has been detained since in a Bangkok prison pending a court ruling on the extradition request from Bahrain -- a move the footballer had pleaded against saying he fears torture if returned.
Monday brought a stunning about-turn from the Bahraini government, which withdrew the extradition request, said Chatchom Akapin, director-general of the International Affairs Department at the prosecutor's office.
"We have been informed that Bahrain wants to withdraw the (extradition) request... if they don't want him, we have no reason to keep him here," he told AFP.
The Thai Corrections Department chief said he had been released from Bangkok remand into the care of Immigration Police.
The Australian government had repeatedly called for Araibi's return and the case has become a cause celebre in the football world, with FIFA also urging the Thai football authorities to intervene.
Football Federation Australia (FFA) last week cancelled the under-23 men's national team plans to hold a training camp in Thailand.
Australian Prime Minister Scott Morrison had also repeatedly pushed for his release, saying that he had written letters to his Thai counterpart Prayut Chan-O-Cha and stressed "how strongly" Australians feel about Araibi's case.
Former Australian football captain Craig Foster, who has been leading a protest in the football community for Araibi's freedom, expressed his "deepest gratitude" for the news.
"My thanks go to the wonderful people of Thailand for your support and to the Thai (government) for upholding international law," Foster posted on Twitter shortly after the news.
Calling his detention a "grave mistake", Kasit Piromya, a board member of the lobby group ASEAN Parliamentarians for Human Rights, said the footballer's case showed the failings of Thailand's "outdated" laws and policies.
"Hakeem should never have been put through this ordeal in the first place," Piromya said.
Thailand's treatment of refugees has been thrust under international scrutiny in recent weeks.
In January, an 18-year-old Saudi woman who ran away from her family arrived in Bangkok's airport, and armed with a smart-phone and a captive Twitter audience, managed to outmanoeuvre Thai authorities and gain refuge in Canada following her pleas for asylum from her "abusive" family.
Bahrain's reversal of Araibi's extradition is surprising.
Only last week the Gulf state issued a statement defending its decision to pursue the footballer after he fled while awaiting trial.
He was convicted in absentia in 2014 for damaging a police station.
But Araibi says the case is bogus and tied to his criticism of Asian Football Confederation (AFC) president Sheikh Salman bin Ebrahim Al Khalifa, a member of Bahrain's ruling family.
The extradition reversal comes a day after Thailand's foreign minister met with Bahrain's Crown Prince Salman bin Hamad Al Khalifa in Manama to "discuss... areas of interest", according to Bahrain's state-run news agency.