The plan, agreed after weeks of wrangling between government officials, bankers and Tokyo Electric executives over who should pay for the crisis, allays investors' fears that a collapse of the power firm would roil financial markets.
It comes as engineers are still working to bring reactors under control at Tokyo Electric's Fukushima Daiichi nuclear power plant north of Tokyo two months after the earthquake and tsunami that led to radiation leaks.
Ratings agency Standard and Poors lowered Tokyo Electric, known as Tepco, to BBB from BBB+, saying in a statement: "The upper limit of compensation remains unclear at this stage, and we expect Tepco's profitability to remain under significant pressure for a very long period."
The government will issue special-purpose bonds to help finance a fund that will allow Asia's largest utility to handle compensation claims expected to run into tens of billions of dollars. No ceiling was set on Tokyo Electric's liabilities.
The government is also considering buying preferred shares from Tokyo Electric, also known as Tepco, if it runs short of capital. It did not provide details on the size of its planned fund injection but lawmakers told reporters earlier this week the bond issue would total about 5 trillion yen (38 billion pounds).
In return for public backing, the government said it will exert control "for a certain period of time" over management of Tokyo Electric and other power utilities, which will also be asked to pay annual premiums into the fund.
Though relieved that the worst may have been averted, investors sold utility stocks, unsettled by the prospect of the government's hands-on role in running the sector.
Bank shares also slid after Japan's top government spokesman said a distinction should be made between loans made before the March 11 earthquake and tsunami and those extended after the disaster and that banks should be asked to cooperate in easing Tokyo Electric's financial burden.
The market interpreted the comments from Chief Cabinet Secretary Yukio Edano as an indication banks may be asked to forgive loans or make other concessions. Shares of Sumitomo Mitsui Financial Group, the utility's main creditor bank, dropped 3.8 percent.
"The government is infringing on private firms' profits. It has violated the profits of utilities and now it's trying to lower the burden for the taxpayer by encroaching on banks' profits," said Kiyoshi Noda, chief fund manager at MU Investments.
Government officials made great efforts to fend off criticism of the scheme as an unjustified use of taxpayer funds. Some have argued the utility, which has a history of safety lapses and is known for its cosy ties with regulators, should have been allowed to fail.
"This framework is not meant as a bailout of Tepco. We made this framework so that compensation can take place swiftly for the victims ... and so that Tepco can supply electricity in a stable way," Trade Minister Banri Kaieda told reporters.
Ministers also sought to alleviate concerns that consumers would end up shouldering much of the burden either in the form of higher electricity tariffs or new taxes, saying the implications for both should be kept to a minimum.
The government will need to pass a new law in parliament to implement the plan and analysts said the opposition, however critical of the scheme, will find it hard to block it as it will effectively mean a delay in compensating disaster victims.
The special-purpose bonds can be turned into cash to handle the initial burst of payouts and Tepco said it aimed to make the first payments to farmers and fishermen affected by the disaster by the end of this month.
More than 70,000 people living in a largely rural area within a 20-km (12 mile) radius of the plant were forced to evacuate. About 136,000 people living within a zone extending another 10 km were advised to stay indoors.
Some analysts have estimated that compensation claims could be anywhere between $20 billion and $130 billion, depending on how long the crisis continues.
S&P said the likelihood that Tepco would receive extraordinary support from the government was very high, but among other factors an increase in radiation leaks from the nuclear plant could raise the risk of further ratings cuts.
While the government tried to navigate the political minefield surrounding the compensation plan, workers at the Fukushima Daiichi plant 240 km north of Tokyo faced another setback after a water leak was discovered in one of the reactors this week.
Tepco said Friday that the discovery of leaking water from the stricken plant's No.1 reactor could complicate its plan to set up a more permanent cooling system for the facility. Some outside experts have been sceptical for weeks about Japan's plan to stabilise the Fukushima Daiichi reactors by January.
Kaieda said a delay in that timetable was now likely.
"I think this is a major factor that will require a change in Tokyo Electric's road map for bringing the situation under control," Kaieda said.
Earlier in the week, Tepco said it had sealed a leak of radioactive water outside the plant's No.3 reactor. The No.2 reactor developed similar leaks which were sealed in April with liquid glass and other substances.
The 9.0 magnitude earthquake and tsunami that followed killed more than 15,000 people, the National Policy Agency said. More than 9,500 people are still missing.
Since the disaster disabled the Fukushima Daiichi plant's cooling systems, Tepco has poured water on the reactors to forestall disastrous meltdowns. The utility has scrambled to find means of storing the contaminated water, some of which has seeped into the ocean.
The world's worst nuclear crisis in a quarter of a century prompted Tokyo to rethink its energy policy that heavily relied on nuclear power as the main alternative to fossil fuels.
Last week, Prime Minister Naoto Kan asked another power utility to close a nuclear plant in an earthquake-prone area. He drew both applause for bold action and fire for what critics said was a rash and poorly planned policy move.
The move also rekindled fears that household and businesses will be hit by rolling blackouts during the summer when electricity use is the highest.
Tepco Friday said it planned to restart conventional thermal plants shut since the March 11 quake and that by the end of July it should be able to supply enough power to meet peak demand.
Kaieda also said the government would do its best to avoid power blackouts.