In exchange for the sales ban and an apology, the Council on American- Islamic Relations (Cair) will urge Muslims around the world not to boycott Nike products. The company also agreed to donate a $50,000 (pounds 31,000) playground to an Islamic elementary school in the United States.
A row broke out after the company used a logo meant to look like flames on a line of basketball shoes to be sold this summer, with the names "Air Bakin'", "Air Melt", "Air Grill" and "Air B-Que". Some Muslims claimed that the logo resembled the word "Allah" written in Arabic script.
The problem was first identified by a Muslim distributor last September, and the logo amended. But Islamic leaders said it was still offensive to their religion when the shoes hit the shops in America and some other parts of the world in March. Now Nike has withdrawn 38,000 pairs of the shoes worldwide.
Nihad Awas, Cair's executive director, said: "We wanted to reinstate confidence in our community that whenever they see something offensive, there could be something done about it."
Roy Agostino, for Nike, said the company immediately diverted supplies away from Islamic states and discontinued production. It had also introduced a review panel into its development process to prevent any similar problems in future.
"We have, through this process, developed a deeper understanding of Islamic concerns and Islamic issues," he said. "As our brand continues to expand, we have to deepen our awareness of other world communities."
This is the second time in recent years that Nike was criticised by the council. In 1995, the shoe company removed a billboard near the University of Southern California that depicted a basketball player with the headline "They called him Allah."
Yesterday's agreement was made public on the same day that Nike issued the findings of an independent inquiry it ordered into the code of conduct implemented in its factories.
The firm, like sportswear rivals Reebok, has come under fire in recent months from the charity Christian Aid. One factory in Vietnam was reported to have made 61 women run two laps around a plant to discipline them for failing to meet production quotas and for wearing improper footwear.
Mr Young, who visited factories in China, Vietnam and Indonesia said he found no evidence of widespread abuse or mistreatment of workers. But he recommended that Nike consider having an ombudsman in each country.