Video courtesy of jn1.tv
The agreement, signed on the sidelines of a meeting of transport ministers in Luxembourg, gradually removes a cap on the number of direct flights allowed between the two over the next five years.
Israel's flag carrier El Al earlier this year called a strike because of concerns that increased competition from Europe would cost jobs. The phase-in period to 2018 is intended to allow airlines to prepare.
A study for the European Commission, the EU executive, found the aviation agreement would have compelling economic benefits, reaching €350 million ($463 million) per year once it is fully implemented.
"We expect to see more direct flights to and from Israel, lower prices, more jobs and economic benefits on both sides," Siim Kallas, European Commission vice-president responsible for mobility and transport, said in a statement.
Transportation Minister Yisrael Katz (L) signs agreement in Luxembourg
The European Union is the most important aviation market for Israel and accounts for 57% of its scheduled international air passenger movements.
Similarly, Israel is a popular destination for European travelers, with a strong potential for growth in tourism.
Some 7.2 million passengers flew between the European Union and Israel in 2011, up 6.8% from 2010, according to the latest Commission data.
In parallel to improving links between Israel and the European Union, work is under way on a unified European air traffic control system, which has fallen behind schedule.
The Commission is threatening to take action against member countries to ensure they join up to a seamless system.
It says the fragmented nature of Europe's airspace leads to more than €5 billion in extra costs each year, which are passed on to passengers in higher ticket prices.
National control of airspace means flights take longer and more inefficient routs, adding an extra 42 kilometers (26 miles) on average to flights in Europe, the Commission says.