Arizona governor Jan Brewer has vetoed a bill that would have allowed businesses run by staff with religious beliefs to deny service to gay and lesbian customers, known as SB 1062.
The controversial measure had faced a surge of opposition from various large corporations, including Delta Air Lines and Major League Baseball.
The governor has been under pressure by opponents and supporters of the bill, after the state's Republican-led Legislature approved it last week.
Brewer has stood by her decision, saying it was the right move for Arizona.
She commented that it was a "broadly" worded bill that could result in "unintended and negative consequences".
She said: "To the supporters of the legislation, I want you to know that I understand that long-held norms about marriage and family are being challenged as never before. Our society is undergoing many dramatic changes."
Brewer added: "However, I sincerely believe that Senate Bill 1062 has the potential to create more problems than it purports to solve. It could divide Arizona in ways we cannot even imagine and no one would ever want.
"Religious liberty is a core American and Arizona value. So is non-discrimination."
The revelation was met by cheers and hugs among protesters outside the state Capitol in Phoenix.
Alessandra Soler, executive director of the American Civil Liberties Union of Arizona, said: "Discrimination has no place in Arizona, or anywhere else. We're grateful that the governor has stopped this disgraceful law from taking effect, and that Arizona will remain open for business to everyone."
In addition to an infringement on gay rights, businesses condemned the measure as a negative move for Arizona's economy. Some argued it could lead to discrimination lawsuits, boycotts and other disruptions.
Supporters of the bill have criticised Brewer's decision. Rush Limbaugh, the conservative radio host, said the governor was "being bullied by the homosexual lobby in Arizona and elsewhere".
Michele Bachmann, the republication representative for Minnesota, said "both opinions" needed to be respected. She said: "Just like we need to observe tolerance for the gay and lesbian community, we need to have tolerance for the community of people who hold sincerely held religious beliefs."