The Armed Forces Tribunal suspended the life sentence awarded to Colonel Dinesh Pathania, Captain Upendra, Havildar Devinder, Lance Naik Lakhmi and Lance Naik Arun Kumar and granted them bail, they said.
The five army personnel had approached the tribunal challenging the punishment given to them following court martial proceedings in 2014.
"It is a bold order by the tribunal. I am very happy. The order has shut misrepresentation in the case to a great extent," said senior lawyer Aman Lekhi, who represented Colonel Pathania at the tribunal.
Army sources said the tribunal has only suspended the life sentence and a final order is expected by it.
The encounter of the three civilians on the intervening night of April 29 and 30 in 2010 in Macchil sector in Jammu and Kashmir had triggered wide-spread outrage and violence in the state.