The Prime Minister and the Archbishop have agreed to recommend to the St John's Co-Cathedral Foundation to drop the proposed underground extension of St John's Co-Cathedral Museum, the DOI said this afternoon.
The decision followed a meeting during which the Archbishop expressed his concerns over the plans, the DOI said.
The two agreed that such a project should not divide the people.
The announcement was made just hours before Parliament was due to debate an Opposition motion urging the government to withdraw its support for the project.
The St John's Co-Cathedral Foundation in a four-line statement said that it agreed with the recommendation by the Prime Minister and the Archbishop that the project should be dropped.
"We have agreed to drop the project" Mgr Philip Calleja, the foundation's president, said when contacted.
Astrid Vella, coordinator of Flimkien Ghal-Ambjent Ahjar, the NGO which first raised the alarm about the project last year, welcomed the news.
"I am delighted for Malta and the world, because St John's is not just a Maltese landmark, but a world heritage treasure which has now been saved from the danger which had been posed.
"We thank all those who contributed to bringing this about, the 1,500 who signed our petition, MPs from both sides who struggled so hard, the Archbishop's timely intervention, Opposition leader Joseph Muscat for his keen personal interest, and not least Dr Gonzi for having the courage and maturity to reconsider his position," Ms Vella said.
"We feel that this is an encouraging sign of a new more mature and less partisan way of doing politics, which bodes well for a future democracy with a greater input from the public."
Jeffrey Pullicino Orlando also welcomed the decision.
"I greet this development with satisfaction and peace of mind. I have been expressing my opposition and concern about this project since November, and I therefore welcome the decision which has been taken," the Nationalist MP said.
The decision was also welcomed by Alternattiva Demokratika in a statement.
The project, announced late last year, would have involved digging up St John Square and part of St John Street down to a depth of some five storeys for the building of an underground extension of the Cathedral museum. The purpose of the project was to enable the museum to better exhibit its treasures, especially the world unique set of 29 Flemish tapestries.
The project was estimated to cost €16m of which €14 million would have come from EU funds.
The project had drawn widespread criticism, including opposition from government MPs Jeffrey Pullicino Orlando, Jesmond Mugliett and Ninu Zammit.
Labour leader Joseph Muscat earlier this month revealed correspondence showing that the Church was also against the underground extension. Earlier he had given notice of the parliamentary resolution urging the government to withdraw its support for the project.