The minority Pirate Party, which campaigns for internet and data freedom, put the bill forward to remove the law that has been in place since 1940.
It came after the attack on the French magazine Charlie Hebdo attack in Paris in January.
The bill said it was "essential in a free society that the public can express themselves without fear of punishment," according to the BBC.
Three party members stood before parliament earlier in the week and each said: "Je Suis Charlie", an expression used globally to express solidarity with the Charlie Hebdo victims.
Following the ruling the party wrote on its blog: "Iceland's parliament has now established the important message that freedom will not give in to bloody attacks."
Previously any person found guilty of blasphemy could have been sentenced to a fine or three months in prison.
The Iceland Monitor website said that the Church of Iceland supported the change.
It claimed is said: "any legislative powers limiting freedom of expression in this way is at variance with modern-day attitudes towards human rights".
However, the Catholic Church of Iceland, the Pentecostal Church and the Church of Iceland's eastern province opposed the changes.
The Catholic Church commented: "Should freedom of expression go so far as to mean that the identity of a person of faith can be freely insulted, then personal freedom - as individuals or groups - is undermined."
The Icelandic Ethical Humanist Association stressed the new law ensured people could still be prosecuted for hate speech.
