Theresa May said that she had blocked the extradition order on grounds of McKinnon's human rights.
McKinnon admits accessing NASA and Pentagon computers, but has always maintained that he was searching for evidence of aliens.
The 46-year-old, who has been diagnosed with Asperger's Syndrome, has been fighting extradition since 2002.
He faces 60 years in jail if convicted in America.
Speaking to MPs today, May said that medical reports had warned that the computer hacker would commit suicide if he was sent to the US.
She said that there was "no doubt" that McKinnon was "seriously ill" with a "depressive illness".
"I have concluded that Mr McKinnon's extradition would give rise to such a high risk of him ending his life," May said.
"The decision to extradite Mr McKinnon would be incompatible with his human rights. I have therefore withdrawn the extradition order against Mr McKinnon."
The director of public prosecutions, Keir Starmer, will now review McKinnon's case file and decide whether charges should be brought against him.
Also today, May has announced plans to change extradition rules to allow the courts to block orders if it is in the interest of justice.