President Vladimir Putin's most vehement critic walked free from court after the appeal verdict, although the embezzlement conviction that disqualifies him from politics remains in place.
The three judges hearing the appeal at the regional court in the northern Kirov region said they would "change the sentence for Alexei Navalny into a suspended term."
The decision came after Navalny made a surprisingly robust showing in the Moscow mayor election in September, coming second behind the Putin loyalist mayor Sergei Sobyanin.
Several thousand Navalny supporters took to the streets of Moscow after his five-year sentence was announced in July.
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"It is all absolutely obvious that all the decisions, first on the real sentence and the change now to suspended, are taken definitely not here but personally by Vladimir Putin," Navalny said after the ruling.
"I have not the faintest idea what is going on in his head, why he changes his decision," he added, to applause from his supporters.
"It is absolutely clear they will not manage to push out me and my colleagues from this political fight. We will continue."
Navalny, who also faces several other criminal probes, said he would appeal the conviction. "Naturally, we will appeal," he told reporters in the courtroom before hugging his wife.
Writing later on his blog, Navalny said it would be strange to call today's decision a victory. "I am not going to be able to run for office," he said.
Today's hearing was uncharacteristically swift, with Navalny saying he saw no sense in participating in debates. The judge said the reasoning for the decision would be presented tomorrow.
A member of the Kremlin's rights council said the suspended sentence might qualify Navalny for an amnesty the Kremlin is considering to mark the 20th anniversary of the Constitution in December.