He was named as the winner of the 100th Nobel Peace Prize in Oslo.
"His reforms give many citizens hope for a better life and a brighter future," Efe news quoted the Nobel committee as saying in a statement.
His efforts deserve recognition and need encouragement, it added.
"The Nobel Committee hopes the prize will strengthen Prime Minister Abiy Ahmed in his important work for peace and reconciliation".
After Ahmed became the Prime Minister in April 2018, Ethiopia reached a peace deal with Eritrea, ending a 20-year military stalemate following their 1998-2000 border war.
Ahmed also introduced massive liberalising reforms to Ethiopia, shaking up what was an extremely tightly controlled nation.
He freed thousands of opposition activists from jail and allowed exiled dissidents to return home.
A total of 301 candidates had been nominated for the prestigious award, including 223 individuals and 78 organisations, the BBC reported.
There had been great speculation over who would win the prize, with the 16-year-old Swedish climate activist Greta Thunberg widely tipped as the favourite.
The prize, worth 9 million Swedish crowns ($900,000), will be awarded in Oslo in December.
Last year's Nobel Peace Prize went to Congolese Denis Mukwege and Iraqi Nadia Murad, both of whom received awards for "their efforts to end the use of sexual violence as a weapon of war and in armed conflicts".
The Peace Prize is the only one of the six prizes awarded outside Sweden, in Oslo, at the request of Alfred Nobel, as Norway was part of the Swedish kingdom at the time.
( With inputs from IANS )