The 1951 story of a vagabond, which also stars Nargis Dutt, is among 20 new entries added to the list.
Time critic Richard Corliss described Raj Kapoor as "the great star-auteur of India's postcolonial golden age of movies - Cary Grant and Cecil B DeMille in one handsome package".
He went on: "The '50s films he headlined and directed became huge hits, not just in his newly-freed homeland, but also across the Arab crescent from Indonesia to North Africa."
He also described Awaara as "a glistening showcase for Kapoor and the great India siren Nargis".
"And, of course, it's a musical, whose main song 'Awaara Hoon', by the famed Shanker-Jaikishan duo, soared to the top of the pop charts in India, China and the former USSR," Corliss concluded.
Raj Kapoor, who modelled his screen persona on Charlie Chaplin's Little Tramp, was 26 years old when he filmed Awaara.
The original All-TIME 100 list published in 2005 included Satyajit Ray's The Apu Trilogy, Mani Ratnam's Nayagan and Guru Dutt's Pyaasa.
Bollywood composer AR Rahman's score for Mani Ratnam's Roja was also among the 10 Best Soundtracks.
Last week, Time magazine ranked director Sanjay Leela Bhansali's 2002 film Devdas eighth among the ten greatest movies of the millennium.
Raj Kapoor was honoured at the 2011 IIFA awards.