Home Secretary Theresa May stopped his extradition on human rights ground after medical reports showed the 46-year-old was very likely to try to kill himself if extradited.
Mr McKinnon was accused by US prosecutors of "the biggest military computer hack of all time", but he claims he was simply looking for evidence of UFOs.
Ms May said the sole issue she was considering was whether "extradition to the United States would breach his human rights".
There was no doubt Mr McKinnon is "seriously ill" and the extradition warrant against him should be withdrawn, she said.
It is now for the director of public prosecutions Keir Starmer QC to decide whether he should face trial in the UK, she added.
The Glasgow-born computer expert allegedly hacked into 97 US government computers from his home in north London between February 1 2001 and 19 March 2002.
He was accused of leaving 300 computers at US Naval Weapons Station Earle in New Jersey unusable immediately after the 11 September 2001 attacks.
US prosecutors also claimed he deleted files that shut down the US army's military district of Washington DC network of over 2,000 computers for 24 hours.
A warrant for Mr Kinnon's arrest was issued in 2005 and officers from Scotland Yard's extradition unit arrested him on 7 June. An order for his extradition was signed on 4 July 2006.
Mr McKinnon was diagnosed as having Asperger's Syndrome in 2008.
He lost a number of appeals against his extradition and in January this year the British High Court expressed concern over the length of time the case was taking.
Both Prime Minister David Cameron, who has held talks on the case with President Barack Obama, and his deputy Nick Clegg have previously publicly condemned plans to send Mr McKinnon to the US.
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