Yahoo senior officers were criticised in a congressional hearing
No details have been given of the settlement, but Yahoo will cover legal costs and will also set up a fund to support other political dissidents.
The case alleged Yahoo had provided information to the Chinese government then used to prosecute the dissidents.
Yahoo said it had to comply with Chinese laws to operate in the country.
But after settling the lawsuit, Yahoo chief executive Jerry Yang said it was "clear to me what we had to do to make this right for them, for Yahoo and for the future".
A statement released by the World Organization for Human Rights USA, which brought the case, said Yahoo had decided to settle the case following criticism at a US Congressional hearing on 6 November.
A Congressional panel criticised Yahoo for not giving full details to its probe into the jailing of a reporter by Chinese authorities.
Yahoo had been "at best inexcusably negligent" and at worst "deceptive" in evidence given to the House Foreign Affairs Committee last year, the panel said.
One journalist cited in the case, Shi Tao, was tracked down and jailed for 10 years for subversion after Yahoo passed on his e-mail and IP address to officials.
He was convicted in 2004 of divulging state secrets after posting online a Chinese government order forbidding media organisations from marking the anniversary of the Tiananmen Square massacre.
Yahoo's original response to the lawsuit acknowledged releasing information to the Chinese government.
But it argued that there was little connection between the information the firm gave and the ensuing arrests and imprisonment of its users.
Michael Callahan, Yahoo's executive vice-president and general counsel, then told a congressional panel in February 2006 that he did not know why the Chinese authorities wanted to trace Shi Tao.
Last week, Mr Callahan wrote to the committee admitting that other Yahoo employees had a document saying it was to do with the "suspected illegal provision of state secrets".