Russian opposition activists condemned the sentence as a blatant move to punish Navalny, 37, for opposing the Kremlin just as he was preparing to stand in Moscow's mayoral election.
The United States said it was "deeply disappointed" and EU states swiftly condemned the verdict, in a new diplomatic controversy that threatens to further strain ties between Moscow and the West.
Judge Sergei Blinov said he found Navalny guilty of defrauding the local government in the northern Kirov region of 16 million rubles ($500,000) in a timber deal while acting as an unpaid advisor to the local authorities in 2009.
"Navalny... committed a grave crime," said Blinov. Navalny's co-accused, Pyotr Ofitserov, was also found guilty and sentenced to four years in a prison colony.
Handed down on Nelson Mandela's 95th birthday, the sentence is the most politically-explosive judgement in Russia since anti-Kremlin tycoon Mikhail Khodorkovsky was jailed in 2005.
"So. Don't all get bored without me," Navalny told supporters in his last Twitter message from the courtroom before being handcuffed. "And most importantly, don't be idle."
He then handed his smartphone to his wife Yulia, hugged her and his mother, shook his father's hand and was led away by bailiffs.
'We will win'
Yulia made a defiant and emotional appearance on the steps of the Lenin district court to declare that the fight against the Kremlin would continue even with her husband in prison.
"I believe that everything will be okay. We will win, and you please must also believe that everything will be great," she said.
Navalny, who emerged as a powerful new political force in mass anti-Putin protests, has dismissed the charges against him as absurd and a Kremlin set-up to end his political career.
Prosecutors in Kirov, a sleepy city 900 kilometres (560 miles) north of Moscow thronged by dozens of reporters for the hearing, had sought a six-year sentence.
Anti-Kremlin activists slammed the verdict as the latest effort by Putin to snuff out the slightest hint of opposition to his 13 years of rule.
"It is completely fabricated from start to finish and even the judge could not say what the reason for the crime was, what was the point," former cabinet minister and anti-Kremlin activist Boris Nemtsov, who was in court, told reporters.
Ex-finance minister Alexei Kudrin, who retains contacts with Putin, wrote on Twitter that the sentence "is not so much a punishment, but aims to isolate him from public life and electoral process".
Top Russian rights group Memorial said the country "now has one more political prisoner" while Amnesty International mocked what it said was "a parody of a prosecution and a parody of a trial".
Khodorkovsky, who is still in jail, said in a statement released through his lawyers that the verdict was "predictable". The last Soviet leader Mikhail Gorbachev said it was "unacceptable" to use the courts to prosecute political opponents.
The verdict will disqualify Navalny, who was on Wednesday registered to run for Moscow mayor, from politics once the appeals process is exhausted.
His campaign chief Leonid Volkov told AFP that Navalny was now pulling out of the Moscow mayor election on September 8 and would urge supporters to boycott the polls.
US ambassador to Moscow Michael McFaul wrote on Twitter that "we are deeply disappointed in the conviction of Navalny and the apparent political motivations in this trial".
Top EU diplomat Catherine Ashton also said the verdict "raises serious questions as to the state of the rule of law in Russia".
Germany's coordinator on Russia, Andreas Schockenhoff, described the legal proceedings as a "show trial" and British Foreign Secretary William Hague warned against the "selective application of the rule of law" in Russia.
Anti-Putin activists vowed to stage protests against the verdict outside the Kremlin walls on Thursday, but the Moscow municipality warned such actions would be broken up by police.
Navalny has said he wants to challenge Putin in the next presidential election in 2018 and coined the phrase "the party of crooks and thieves" to describe the ruling United Russia party.
In a typically uncompromising gesture, Navalny this week published a detailed report accusing one of Putin's closest allies, Russian Railways head Vladimir Yakunin, of possessing vast undeclared property and business assets.
Navalny has become a hero for many in the Internet-savvy middle class who yearn to live in a different Russia but he has yet to win wide recognition beyond his powerbase in Moscow.