In a surprise statement by US President Donald Trump, who helped broker it, the countries called the accord "historic" and a breakthrough toward peace.
Until now Israel has had no diplomatic relations with Gulf Arab countries.
But shared worries over Iran have led to unofficial contacts between them.
Palestinian leaders were reportedly taken by surprise. A spokesman for President Mahmoud Abbas said the deal amounted to "treason", and the Palestinian ambassador to the UAE was being recalled.
President Trump called the deal between Prime Minister Netanyahu and Abu Dhabi Crown Prince Mohammed bin Zayed Al Nahyan "a truly historic moment". It marks only the third Israel-Arab peace deal since Israel's declaration of independence in 1948, after Egypt and Jordan.
"Now that the ice has been broken I expect more Arab and Muslim countries will follow the United Arab Emirates," he told reporters in the Oval Office, saying there would be a signing ceremony at the White House in the coming weeks.
Earlier, in response to a President Trump's tweeted announcement, Mr Netanyahu wrote in Hebrew: "Historic day."
A foreign policy victory?
In a TV address Mr Netanyahu said he had "delayed" West Bank annexation plans, but those plans remain "on the table". Annexation would make some West Bank areas officially part of Israel.
"There is no change in my plan to apply our sovereignty to Judea and Samaria [West Bank] in full co-ordination with the US. I'm committed to it. That hasn't changed. I remind you that I was the one who put the issue of sovereignty over Judea and Samaria on the table. This issue remains on the table," he said.
Mr Netanyahu said Israel would co-operate with the UAE in developing a coronavirus vaccine, in energy, water, environmental protection and many other fields.
Analysts say the deal could mean a foreign policy victory for President Trump, who will seek re-election in November, and give a personal boost to Prime Minister Netanyahu, who is on trial for alleged corruption.
Both leaders have seen their approval ratings drop because of their response to the coronavirus pandemic. And in Israel, some on the right who want to annex the West Bank expressed anger over the announcement.
