Asylum-seekers arriving by boat will no longer be resettled in Australia but will go to Papua New Guinea, Prime Minister Kevin Rudd has announced.
The news came as Mr Rudd set out an overhaul of asylum policy ahead of a general election expected shortly.
Australia has seen a sharp rise in the number of asylum-seekers arriving by boat in recent months.
Following the news, rioting reportedly broke out at an asylum centre in Nauru. It was unclear if there was a link.
"Police have been called in to help with a major disturbance at the asylum seeker detention centre on Nauru," the Australian Broadcasting Corporation (ABC) reported.
The cause of the disturbance, involving 150 detainees, had not been established, ABC added.
Mr Rudd had said the "hard-line decision" was taken to ensure border security. It was also aimed at dissuading people from making the dangerous journey to Australia by boat.
"Our country has had enough of people-smugglers exploiting asylum-seekers and seeing them drown on the high seas," he said.
The deal - called the Regional Settlement Arrangement - was signed by the Australian and PNG leaders on Friday.
Mr Rudd, who ousted Julia Gillard as Labor Party leader amid dismal polling figures last month, made the announcement in Brisbane flanked by PNG Prime Minister Peter O'Neill.
"From now on, any asylum-seeker who arrives in Australia by boat will have no chance of being settled in Australia as a refugee," Mr Rudd said.
Under the agreement, new arrivals will be sent to PNG - which is a signatory to the United Nations Refugees Convention - for assessment and settled there if found to be a refugee.
To accommodate the new arrivals, an offshore processing centre in PNG's Manus island will be significantly expanded to hold up to 3,000 people. No cap has been placed on the number of people Australia can send to PNG, Mr Rudd said.
"The new arrangements will allow Australia to help more people who are genuinely in need and help prevent people smugglers from abusing our system."
The rules would apply to all those arriving in Australia by boat from today, Immigration Minister Tony Burke said.
In return, Australia is to channel aid to PNG, including to a major regional hospital and the university sector, The Australian reported. No costs were disclosed in connection with the deal.
Boat arrivals have soared in the past 18 months, with most asylum seekers coming from Iraq, Iran, Sri Lanka, Afghanistan and Bangladesh. They make their way to Indonesia and from there head to Christmas Island, the closest part of Australian territory to Java.
They travel in boats that are often over-crowded and poorly-maintained. Several have sunk in recent months, killing passengers.
Last year, the Australian government reintroduced a controversial policy under which people arriving by boat in Australia are sent to camps in Nauru and Papua New Guinea for processing.
But the policy has so far failed to deter boat people, who are arriving in increasing numbers. It has also been strongly criticised - most recently by the UNHCR - for the conditions which asylum-seekers face at the camps.
Late on Thursday, Indonesia said it had agreed to stop giving Iranians visas on arrival as part of the measures to ease the problem.
'Turned its back'
Asylum has become a key election issue in Australia and polls must be called before the end of November.
Opposition leader Tony Abbott - whose party looked on course to trounce Labor at the polls before the leadership change - has said he will turn boats back to Indonesia when safe to do so.
Responding to this agreement he said: "While this certainly is a very promising development in offshore processing, it is about processing boat people, it's not about stopping the boats and that in the end is what we have to have."
Human rights advocate David Manne, meanwhile, said Australia had signed up to international conventions to protect "people who come to its shores, not exposing them to further risks elsewhere".
"The fact remains that Australia hosts only 0.3% of refugees worldwide and yet what we see here is a policy designed not only to deter asylum seekers from coming and seeking refuge in Australia, but one that also proposes to shift our responsibilities on to others," ABC quoted him as saying.
Rights group Amnesty International's regional refugee co-ordinator Graeme McGregor said the move would be marked "as the day Australia decided to turn its back on the world's most vulnerable people, closed the door and threw away the key".