"The basis upon which the appellants were convicted is shown to have been unsound," the Court of Appeal ruled.
The Muslim students were arrested in July 2006 on charges of downloading "extremist" materials and were sentenced to between two and three years in prison.
The prosecution claimed they had been "intoxicated" by extremism and were planning to go to Pakistan for training before fighting in Afghanistan.
The students denied the charges, saying they were researching ideology, including visiting websites about violence.
The students were prosecuted under section 57 of the 2000 Terrorism Act, which makes it an offence to have books or items inciting terrorism.
The appeal court said the prosecution's case against the Muslim students was weak.
"While they lent support to the prosecution case that the appellants had formed a plan to go to Pakistan to train and then to Afghanistan to fight, there was nothing that evidenced expressly the use, or intention to use, the extremist literature to incite each other to do this."
The ruling was the first to be quashed by the court of appeal since Washington's so-called "war on terror" in 2001.
The Home Office said it would study the ruling carefully.
Nightmare
Usman Malik, one of the student, said his arrest had made his life a hell.
"The last 18 months have been worse than a nightmare," he said through his lawyer, denying charges of supporting violence.
"I was away from home for the first time when I was arrested and accused of being a terrorist.
"I was never a terrorist and have never supported violence."
Imran Khan, the lawyer of student Aitzaz Zafar, said young Muslims seeking to explore the world of their religion should no longer be victimized.
"My client is over the moon. He says it is surreal and cannot see why he has spent the last two years in prison for looking at material which he had no intention of using for terrorism," he said.
"Young people should not be frightened of exploring their world."
The Muslim Council of Britain, the umbrella representation body of British Muslims, has complained that some Muslims are being criminalized under the draconian anti-terror measures in Britain for "silly thoughts."
British Muslims, estimated at nearly two million, have been in the eye of storm since the July 2005 bombings, which killed 56 people, including four Muslim bombers.
The sizable minority has vehemently condemned all terrorist attacks and offered full cooperation with police.
A recent Populus survey found a whooping 98 percent of British Muslims would feel shame if a family member decided to join Al-Qaeda.
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