The Saltire will fly over Hampden during Olympic football matches following a review by organisers.
The original ban sparked a protest last week after the London Organising Committee (LOC) confirmed that only flags of competing nations could be flown at Games venues under Olympic rules.
That would have forced the SFA to take down the Saltire flags that traditionally fly over the stadium, because Scots athletes compete as members of the Great Britain and Northern Ireland team.
The rules were even interpreted as banning Scottish fans from flying the flag from the stands, although organisers insisted a "common sense" approach would be taken.
A spokesman for the London 2012 organising committee confirmed the change of policy, saying: "We are delighted to confirm that the Scottish flag will be flying from Hampden during Games time.
"Scottish fans are more than welcome to bring and fly both Scottish and British flags."
Alyn Smith, a SNP Member of the European Parliament, complained last week to Lord Coe, chairman of the organising committee.
"This move shows common sense by the organisers and is wholeheartedly welcome. It shows they are prepared to listen and that is something to be commended," said Mr Smith.
"Of course, the Saltire should never have been banned in the first place, but better late than never."
He thanked people for joining his campaign through an online petition.
"Scotland's national flag normally flies above Hampden for 365 days of the year and to have removed it would not only have gone against long-standing tradition, but would also have made a mockery of the Olympic ideal of international companionship and respect," he added.
Images from the 1992 Games in the Catalan capital Barcelona showed the flags of Catalonia and Spain given equal status, which Mr Smith said sets a precedent for Scotland.
During the 2002 Winter Olympics in Salt Lake City skier Alain Baxter, from Aviemore, Highlands, was ordered by the British Olympic Association to cover up a blue and white Saltire he had dyed into his hair before competing.
Baxter went on to be stripped of the bronze medal he won in the slalom after he unwittingly used a nasal spray that was on the list of banned substances.
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