In a further capitulation to international pressure, the Foreign Minister, Ali Alatas, also said the imprisoned East Timorese leader, Xanana Gusmao, would be released.
The announcements were given a cautious welcome around the world, especially after reports of new killings in the former Portuguese colony, annexed by Indonesia in 1975.
But they represent a turning- point in one of the world's most tragic and vicious small wars. Mr Alatas said East Timor will be granted "special autonomy", short of full independence.
But he added that parliament would consider allowing the territory to break away completely after elections scheduled for June. "If the Indonesian proposal ... to give special status to East Timor is rejected," he said, "the Cabinet will suggest to the next MPR [the parliament] to consider letting go of East Timor."
The U-turn is the result of a combination of foreign lobbying, pressure from within the Indonesian government and Jakarta's desperate economic plight. The United Nations has never accepted Jakarta's incorporation of East Timor. Australia was the only country to recognise Indonesian rule over the territory. This month, however, after years of criticism from lobbying groups and denunciations from Portugal, Australia officially announced that it may support independence.
Yesterday the British Foreign Secretary, Robin Cook, said: "Our view all along has been that the solution to the problem of East Timor must be one that is acceptable to to peoples of East Timor.
"We regard this very much as a step in the right direction."
But East Timor's 800,000 inhabitants have little reason to trust Indonesia's offer. Almost everyone has lost family and friends in the war. "I am very sceptical," said Roque Rodrigues, an independence campaigner based in Lisbon. "Indonesia often says one thing and then does another."
Aid workers recently in the territory say 2,700 refugees have fled their homes after violence between rival factions of pro-independence Timorese and gangs of thugs armed and trained by the Indonesian army. In the past, Jakarta has justified its claim to East Timor by fomenting conflict and moving in troops to "pacify" the region.
Pressure for Indonesia to settle the problem has mounted since the end of the 30-year rule of President Suharto. Much of this has focused on Alexandre "Xanana" Gusmao, commander of the East Timorese resistance, who was sentenced to 20 years' prison in 1993.
Yesterday Mr Alatas outlined a deal maintaining the fiction that Mr Gusmao is a normal prisoner. "He will not be any more in the jail, but he will be in a separate house. [But] don't call it house arrest."Reuse content