The prize, announced on what would have been the former Swedish prime minister's 80th birthday, was also awarded to lawyer and human rights activist Mossaad Mohamed Ali, who runs a centre to help victims of torture in the war-torn Sudanese province of Darfur.
The award to Annan, who is from Ghana, was said by the Olof Palme Memorial Fund to be in honour of his "courage" as leader of the UN.
"In the spirit of Dag Hammarskjöld he has striven to make the UN live up to its full responsibility for the maintenance of international peace and security," the award citation said.
In what may be interpreted as a dig at the United States, the fund said that Annan "defended the UN principles and international law when these were challenged by the mightiest authorities."
Mossaad Mohamed Ali runs the Amel Centre for the Treatment and Rehabilitation of Victims of Torture in South Darfur. The fund described Ali as "an outspoken and courageous critic of crimes against human rights that were inflicted on the most exposed people of Darfur."
The Olof Palme Prize, worth $75,000, is awarded for 'outstanding achievement in the spirit of former Swedish prime minister Olof Palme.'
Palme, who was murdered in 1986 while still in office, was a controversial figure in international affairs. He was an outspoken critic of the United States for its conduct of the Vietnam war, a vocal supporter of the ANC in South Africa and the Palestinian Liberation Organization, and was criticised for meeting Fidel Castro.
The prizewinners are annouced annually on Palme's birthday, 30th January. Palme would have turned 80 on Tuesday.