Liu, a leading dissident since the 1989 Tiananmen Square student movement, was arrested in December 2008 after co-authoring Charter 08, a call for democratic reforms, and is serving 11 years for incitement to subvert state power. He also served three years in a labor camp in the 1990s.
The move by the Norwegian Nobel Committee is certain to anger Beijing, which last week warned Norway that it would harm relations. A Foreign Ministry spokeswoman said last week honoring Liu would contradict the aims of the prize.
U.S President Barack Obama, who won the prize last year, welcomed the announcement, saying Liu has been "an eloquent and corageous spokesman for the advance of universal values through peaceful and non-violent means."
"This award reminds us that political reform (in China) has not kept pace, and that the basic human rights of every man, woman and child must be respected. We call on the Chinese government to release Mr. Liu as soon as possible," Obama said in a statement released by the White House.
Liu, 54, an author and former academic, may well not know he has won. His lawyer had told him he was nominated, but he is not allowed to talk about current affairs with visitors to his prison in Jinzhou, Liaoning province.
He is allowed to see relatives for an hour each month. His wife, Liu Xia, had said she believed he was unlikely to win the prize, but that the attention he gained had won him better conditions.
Catherine Baber, deputy Asia-Pacific director at Amnesty International, praised the award and called on China to respond by releasing all prisoners of conscience.
"This award will no doubt infuriate the Chinese government by putting its human rights record squarely back into the international debate," said Sophie Richardson, Asia advocacy director at Human Rights Watch, who also called for Liu's release. "But this Nobel Prize honors not only Liu's unflinching advocacy; it honors all those in China who struggle daily to make the government more accountable."
Charter 08 was originally signed by about 300 Chinese scholars, lawyers and officials. Since then, many of the original signatories have been harassed by the authorities, Amnesty International said. Another 12,000 people have signed in support online.