The vast project will be by far the biggest foreign investment in Russia since the fall of Communism and is likely to become a blueprint for future energy developments by Western companies.
It will open up the once closed island - over which Korean Airlines flight 007 was shot down 10 years ago - as one of the world's biggest oil-producing regions, one to rival the North Sea.
Shell and its partners - a consortium of five oil companies from the United States, Japan and Britain - have been in talks with Russian state negotiators and the island's representatives for more than two years, but have now reached a crucial breakthrough over the deal.
The key terms have been agreed and signed by the two sides recently, paving the way for full ratification from Moscow and the Russian federal parliament later this month.
The project, known as Sakhalin 2, offers Western banks an opportunity to provide project finance.
Although the bulk of manufacturing orders are expected to be placed with Russian industry, some of Scotland's specialist oil services could also share in the bonanza.
Other ventures are planned for the Sakhalin area by major US groups including Exxon, Amoco and Mobil.
Sakhalin 2 involves the development of the Piltun-Astokhskoye and Lunskoye fields, which contain reserves of 750 million barrels of oil and 14 trillion cubic feet of gas. Oil and gas from the fields will be transported by pipeline to the shore and a further 350 miles south along the island to Korsakov, where a liquified natural gas plant will also built,
It will take at least five years to complete because the severe climate (and the risk from passing icebergs) means work is only possible between May and October.
Despite the scale of the project, its key attraction is its closeness to big Far Eastern markets, including Japan. 'It is a very large and challenging plan, but Sakhalin is uniquely placed geographically,' a consortium member said.
'One of the bugbears of producing oil in Russia is that you have to haul it for thousands of miles to reach a market. The beauty of this project is that the market is at your door and you can get there without building a vast infrastructure.
'Although some infrastructure will still be needed on Sakhalin, that is a relatively manageable task.'
A crucial element of the Shell deal is that the Russian government has dropped earlier plans to slap a punitive export duty on its oil. The tariff, amounting to about dollars 5 per barrel, had threatened to jeopardise many foreign-backed oil ventures because of the additional risk.
However, the final agreement is a conventional 25-year production-sharing contract in which Russia could receive close to 50 per cent of the consortium's output despite making no equity investment in the project.
The terms are based on a complex formula that covers royalties, profits and tax. Formal ownership of the oil will remain with Russia, but the consortium will have priority in recovering the project costs.
After that, the Russian government has the choice of taking its share in cash or oil.
After the remaining regulatory formalities are completed, the consortium will pay Russia a bonus of dollars 50m; another dollars 100m will go towards a social development fund for the island; and about dollars 160m is to be paid to Russian companies that took part in geological work.
Although the island was once occupied by the Japanese army and its proximity to the disputed Kurile islands makes it a politically sensitive area, the Japanese government is understood to be a keen supporter of the project.
(Map omitted)Reuse content