The apex court's constitution bench headed by Chief Justice R.M. Lodha, while striking down the Kerala Irrigation Water Conservation Act, said the water level in the dam could be increased to 142 feet from 136 feet.
Holding that there was no threat to the safety of the 120-year-old dam, the court set up a three-member committee under whose supervision the water level will be increased.
Kerala and Tamil Nadu have been at loggerheads over the Mullaperiyar dam, built under a 1886 pact between the then Maharaja of Travancore and the British Raj.
While the dam is located in Kerala, its waters serve Tamil Nadu. Kerala is seeking a new dam and has offered to build and fund it but Tamil Nadu has been engaged in a protracted legal battle.
The apex court said the three-member panel, comprising a representative each of the Central Water Commission (CWC), Kerala and Tamil Nadu, will carry out regular inspections. The CWC will head the committee.
Kerala Chief Minister Oommen Chandy said it was unfortunate that the Supreme Court did not consider people's safety while striking down the act restricting the water level in the Mullaperiyar dam at 136 feet.
Chandy said Kerala has no qualms in giving water to Tamil Nadu but safety was paramount.
"The court, it seems, did not look into the safety of the people living near the old dam. The state cabinet will now meet to decide what needs to be done," Chandy said.
As soon as the verdict came, people living in and around the dam near Idukki district in Kerala voiced their resentment and called for a shutdown in the state Thursday.
"We expect all political parties to cooperate with our move to call for a strike to protest against the verdict," said Joy Nirappel, who heads the Mullaperiyar Action Council.
Kerala Minister for Water Resources P.J. Joseph said Kerala will now seek legal advice.
Opposition leader V.S. Achuthanandan said judgement would only heighten the fears of 3.5 million living in Idukki, Pathanamthitta, Kottayam, Ernakulam and Alappuzaha districts vis-a-vis the dam.
"I wish the state government immediately calls a special session of the assembly to discuss this burning issue," he said.
Political leaders in Tamil Nadu welcomed the Supreme Court judgement.
PMK founder S. Ramadoss said though justice had been delayed, the rights of Tamil Nadu had been upheld.
DMK president M. Karunanidhi also expressed happiness.
MDMK general secretary Vaiko said the judgement was a death blow to Kerala's wayward attitude.