El-Sarraj, who in 1977 became the first psychiatrist to practice in Gaza, is the founder of the Gaza Community Mental Health Programme (GCMHP), a non-governmental organisation focused on improving the mental well-being in the Palestinan community.
The 66-year-old psychiatrist has "in his professional and political work ... stood on the side of the individual human being, regardless of nationality, gender or social position," the Olof Palme Memorial Fund said in a statement.
"He has brought into the light the destructive influence of repression on mental health. He has shown the connections arising between confinement, hopelessness, desperation and violence, and how this is neglected by both Palestinian and Israeli authorities," it added.
El-Sarraj said he was surprised at the award but happy.
"I am proud and happy to receive this prize but I consider that the real heroes are the victims of violence, torture and war, not me," he told AFP in the Gaza Strip.
"This prize gives me hope and encourages me to continue to fight to defend those whose rights have been abused in Palestine, by the Israelis or the Palestinian Authority, and to work for justice and peace."
The Palestinian physician, who completed his medical studies in Alexandria and London, witnessed before the United Nations-mandated Goldstone Commission on the war crimes committed by both sides during Israel's war in Gaza two years ago.
El-Sarraj will receive his award and the $75,000 prize money at an official ceremony at the Swedish parliament on January 28.
The Olof Palme award for outstanding achievement, aimed at promoting peace and disarmament and combatting racism and xenophobia, was created in memory of a popular Swedish prime minister who was gunned down by a lone attacker in February 1986, shortly after leaving a Stockholm cinema.
Danish writer and debater Carsten Jensen won the 2009 prize, while other former laureates include Congolese gynecologist Denis Mukwege, former UN secretary general Kofi Annan and Myanmar's pro-democracy leader Aung San Suu Kyi.