The prisoner release followed a weekend decision by the Israeli parliament to shutter a series of settlements, but also came as Palestinian President Mahmoud Abbas faced growing opposition from within his own parliament.
In West Bank and Gaza communities, thousands turned out to welcome the freed Palestinians.
"I cannot believe that I'm smelling the air of freedom, that I will see my family," Suhail Abu Madala, who spent four years in prison, told the Associated Press. "Nothing can describe my joy and my feelings."
None of the 500 freed had participated in attacks against Israelis, but both leaders of the Palestinian Authority and militant groups like Hamas, said they would not be satisfied until the additional 7,500 prisoners are released.
"There will be no peace as long as there is a single prisoner in Israeli jails," the Hamas leader in the West Bank, Hassan Yousef, shouted through a bullhorn, according to the Associated Press.
Although the demand for additional releases and the accidental shooting death of a Palestinian during the celebrations tempered the mood, those freed still hailed the day.
"All I care about now is to make it up to my son ... I cannot describe how happy I was when I had him in my arms for the first time in my life," Reuters quoted Mohammad Abu Libdeh as saying. Libdeh's 4-year-old son was born while he was in jail on weapons charges and for belonging to a militant group.
Israel's decision to free the prisoners is seen as an effort to strengthen the hand of new Palestinian President Mahmoud Abbas as he works to control the militant violence and restart peace efforts.
But even as televised scenes of celebration played on Palestinian television, Abbas' government faced growing challenges from within the Palestinian parliament.
Palestinian Prime Minister Ahmed Qureia presided over a stormy session in which lawmakers derailed the expected approval of Abbas' Cabinet. Legislators harangued Qureia with complaints about continued government corruption and a lack of reform within the Palestinian Authority.
Qureia twice slammed the microphone down as the debate turned more heated and the final vote was put off until at least Tuesday.
Additionally, Reuters reported at least one senior Palestinian, Mohammad Dahlan, refused to join the Cabinet.
"Dahlan refuses to join the Cabinet because it does not fulfill the hopes of the Palestinian people and lacks the true standards of change," a Palestinian official told Reuters.
President Bush, traveling in Europe, urged the Abbas government to put forward reforms, saying, "The Palestinian people deserve a government that is representative, honest and peaceful."
"President Abbas has the opportunity to put forward a strategy of reform, which can and will gain financial support from the international community," Mr. Bush said. "I hope he will seize the moment."
Despite the internal political squabbles among Palestinians, the release of the 500 prisoners represented the latest in a series of good-will gestures aimed at getting peace talks back on track and rewarding efforts by Abbas to crack down on militant attacks.
The Israeli Cabinet voted Sunday to leave Gaza and close four settlements in the northern West Bank. The Cabinet also voted to revise the line of the controversial West Bank barrier to run closer to the nation's pre-1967 frontier.
The vote marked the first time since Israel took control of the West Bank in 1967 that the Jewish state agreed to close some of the dozens of settlements built there.
Despite the final approval for the plan set to begin in July, Pinchas Wallerstein, one of the leaders of settlers, called on supporters to begin "an aggressive and strong struggle" but stopped short of calling for violence.
The revised barrier is also seen as a major step towards consolidating the possible borders of a Palestinian state should peace talks progress to so-called final status issues. As approved Sunday, Vice Premier Simon Peres said only 6 to 7 percent of the West Bank would remain in Israeli hands.
Western leaders have hailed the moves by both sides, which have also included a Palestinian crack down on security officials who allow militants to operate in their areas and an Israeli decision to end the policy of demolishing the homes of suspected terrorists.
"Our greatest opportunity, and our immediate goal, is peace in the Middle East," President Bush said.