Mr Fonseka was arrested two weeks after he unsuccessfully challenged Mr Rajapaksa's re-election in January 2010.
Advertisement: Story continues below
Mr Fonseka, 61, is credited with leading the military campaign that crushed the Tamil Tiger rebels in May 2009, but also encouraged international calls to investigate the alleged deaths of up to 40,000 civilians in the war's final months.
The once-feared Mr Fonseka was regarded by the US as a political prisoner and Washington repeatedly called for his release.
Mr Rajapaksa issued the release order after his Foreign Minister, Gamini Lakshman Peiris, met the US Secretary of State, Hillary Clinton, in Washington on Friday for talks on the island's human rights record.
Mrs Clinton believed that Sri Lanka has put forward ''a very serious'' plan for reconciliation after its civil war, and urged the government to move forward on protecting human rights, the State Department said.
The US had asked Sri Lanka to improve press freedom and human rights, and also ''de-militarise'' the former war zone in the island's north. But Mr Rajapaksa, in an address to the nation on Saturday, ruled out a troop withdrawal.
In the speech marking the victory anniversary, he made no reference to his erstwhile military chief, who has been stripped of his rank and pension by a court martial.
Mr Fonseka fell out with Mr Rajapaksa over who should take credit for ending the savage ethnic bloodshed which killed up to 100,000 people between 1972 and 2009.
He had also angered the government by saying he would gladly testify before any international tribunal investigating possible war crimes charges, after the UN said thousands of civilians had been killed in the last months of fighting.
The terms of his release were not immediately clear. But his wife, Anoma, said on Thursday, after meeting Mr Rajapaksa, that she expected him to ''be cleared of all charges and released unconditionally''.
Two weeks after his election defeat in early 2010, Mr Fonseka was detained on charges of meddling in politics and corruption relating to military procurements, and was given a 30-month jail sentence in September 2010.
In November 2011, he was sentenced to three more years in jail.
SMH