The president declared that the policy change is "the right thing to do."
Under the new policy, people younger than 30 who arrived in the United States before the age of 16, pose no criminal or security threat, and were successful students or served in the military, can get a two-year deferral from deportation and apply for work permits.
Participants must prove they have been living in the country continuously for at least five years.
The change is part of a department effort to target resources at illegal immigrants who pose a greater threat, such as criminals and those trying to enter the country now, Napolitano said.
The move addresses a concern of the Latino community and includes some of the provisions of a Democratic proposal called the DREAM Act that failed to win enough Republican support to gain congressional approval.
Obama has been criticized by Latino leaders for an overall increase in deportations of undocumented immigrants in recent years. Last year, U.S. Immigration and Customs Enforcement removed 396,906 illegal immigrants, the largest number in the agency's history.
Obama and Napolitano have called for Congress to pass the DREAM Act, which would put into law similar steps for children of illegal immigrants to continue living and working in the country.
Republicans who blocked Democratic efforts to change immigration laws have condemned the move, with some calling it an improper maneuver to skirt congressional opposition.
Rep. Steve King of Iowa, a GOP foe of Democratic proposals on immigration, threatened in June to sue to stop Obama "from implementing his unconstitutional and unlawful policy."
Republican Sen. Lindsey Graham of South Carolina has called the decision "a classic Barack Obama move of choosing politics over leadership," while House Judiciary Committee Chairman Lamar Smith, R-Texas, has called the change a "decision to grant amnesty to potentially millions of illegal immigrants."
Others predicted the move will tighten an already poor job market for young Americans.
However, Democratic Sen. Dick Durbin of Illinois, who sponsored the DREAM Act, said it "will give these young immigrants their chance to come out of the shadows and be part of the only country they've ever called home."
Presumed GOP presidential candidate Mitt Romney said in June that the issue needs more substantive action than an executive order, which can be replaced by a subsequent president.
As president, Romney said, he would seek to provide "certainty and clarity for people who come into this country through no fault of their own by virtue of the actions of their parents."
Latinos make up the fastest-growing immigrant population in the country, and the Latino vote is considered a crucial bloc for the November presidential election.
A spokeswoman for a major Latino group, the National Council of La Raza, hailed the administration's move.
"In light of the congressional inaction on immigration reform, this is the right step for the administration to take at this time," NCLR spokeswoman Laura Vazquez said in June.