The 75-year-old was honored "for having created new poetic expressions within the great American song tradition," the Swedish Academy said.
The choice was met by gasps and a long round of spontaneous applause from journalists attending the prize announcement. The folk rock singer had been mentioned in Nobel speculation over the years, but was never seen as a serious contender.
The Academy's permanent secretary Sara Danius said Dylan's songs were "poetry for the ears" while acknowledging that some might find Dylan a "strange" choice.
"... if you think back to Homer and Sappho, you realize that was also aural poetry. It was meant to be performed, together with instruments," she said.
"But we still read them, 2,500-some years later ... And in much the same way you can read Bob Dylan too. And you realize that he is great at rhyming, great at putting together refrains and great at poetic images," she told AFP.
Embodying both "the intellectual and popular tradition," he had been influenced by the Delta blues, folk music from the Appalachians and others such as the 19th-century French poet Arthur Rimbaud who wrote in a surrealist style, she added.
"Dylan has the status of an icon. His influence on contemporary music is profound," the Academy wrote.
Author Salman Rushdie, often tipped as a possible Nobel winner himself, hailed Dylan as a "great choice."
"From Orpheus to Faiz, song and poetry have been closely linked. Dylan is the brilliant inheritor of the bardic tradition," he tweeted.
US President Barack Obama also tweeted his congratulations to Dylan, whom he called "one of my favorite poets."
Famously private, Dylan himself had yet to comment on the prize more than five hours after the announcement.
The Nobel is the latest accolade for a singer who has come a long way from his humble beginnings as Robert Allen Zimmerman, born in 1941 in Duluth, Minnesota, who taught himself to play the harmonica, guitar and piano.
Captivated by the music of folksinger Woody Guthrie, Zimmerman changed his name to Bob Dylan — reportedly after the Welsh poet Dylan Thomas — and began performing in local nightclubs.
After dropping out of college he moved to New York in 1960. His first album contained only two original songs, but the 1963 breakthrough "The Freewheelin' Bob Dylan" featured a slew of his own work including the classic "Blowin' in the Wind."
Armed with a harmonica and an acoustic guitar, Dylan confronted social injustice, war and racism, quickly becoming a prominent civil rights campaigner — and recording an astonishing 300 songs in his first three years.
“Bob Dylan caught the spirit of the 1960s when he came into Greenwich Village from Minnesota," says Peter Dreier, who writes about American politics and teaches at Occidental College in Los Angeles. "And it was the time of the civil rights movement, and the beginning of the anti-war movement, beginning of the baby boom, and he was right there writing and singing about those issues."
Dylan's first British tour was captured in the classic documentary "Don't Look Back" in 1965 — the same year he outraged his traditionalist folk fans by using an electric guitar at the Newport Folk Festival on Rhode Island.
The following albums, "Highway 61 Revisited" and "Blonde on Blonde," won rave reviews, but Dylan's career was interrupted in 1966 when he was badly injured in a motorcycle accident and his recording output slowed in the 1970s.
By the early 1980s his music reflected the performer's born-again Christianity, although this was tempered in successive albums, with many fans seeing a resurgence of his explosive early-career talent in the 1990s.
Dylan may have moved away from political music, but the connection between his early music and political activism persists.
"It doesn’t really matter what Dylan thinks he was," Dreier says. "The spirit of his music continues today, whenever there is talk about rebellion and protest, always in the background we’re hearing 'Blowing in the Wind' and 'The Times are A Changin’' and so Bob Dylan’s legacy lives on even though he denies he was a protest singer.”
Since the turn of millennium, as well as his regular recording output and touring, Dylan has also found time to host a regular radio show, the Theme Time Radio Hour, and published a well-received book "Chronicles," in 2004.
He was the focus of at least two more films, Martin Scorsese's 2005 "No Direction Home" and "I'm not There" in 2007 starring Christian Bale, Heath Ledger and Cate Blanchett.
Over the years Dylan has won 11 Grammy awards, as well as one Golden Globe and even an Oscar in 2001, for best original song "Things have Changed" in the movie "Wonder Boys."
'Class of his own'
Speculation prior to Thursday's announcement had focused on Syrian poet Adonis and Kenyan writer Ngugi wa Thiong'o.
Reactions to the choice of Dylan were mostly positive, though some disapproved.
The Academy has been known to push the limits of the definition of literature, honoring for example Winston Churchill in 1953 for his wartime speeches.
Swedish music journalist Stefan Wermelin said the Academy was known for its varied choices.
"Sometimes it's someone unknown whom few have read, and sometimes they pick someone who has popular appeal," he said.
"But this is the first time the prize has gone to a musical form of expression and in that genre Dylan is totally in a class of his own."
But Per Svensson, culture writer at Swedish regional daily Sydsvenskan, called this year's choice "incredibly depressing" and a "Trumpification" of the prestigious prize to appeal to the masses.
Swedish author Johanna Koljonen noted meanwhile — to misquote Dylan — that the times are changing at the venerable 230-year-old Academy.
"The Swedish Academy works with a bit of delay so ... in 10 to 20 years we'll be having talks about Jay Z and Kanye, and that would be great."