The resolution was confirmed ahead of a jury trial which was due to begin at the High Court in Belfast next week.
A judge was told the settlement took into account the wider interests of unionism, with both sides paying their own costs.
It included an acceptance that legal fees received by Mr Allister, a senior barrister and Traditional Unionist Voice leader, was for cases completed before his election to the European Parliament.
It was also accepted that he did not personally negotiate with Sinn Féin.
Mr Paisley, the Democratic Unionist Party MP for North Antrim, was being sued by Mr Allister over allegations contained in an election pamphlet.
The pair stood against each other in the 2010 Westminster poll.
Mr Allister had sought to have distribution of the leaflet banned before the election.
He claimed it could have serious consequences because of the potential impact on the thinking of voters in the constituency.
Although he failed to secure an injunction, his legal team then launched defamation proceedings against Mr Paisley and the leaflet's printers.
A jury was set to be sworn in on Monday for what was expected to be a week-long trial.
But ahead of the hearing, lawyers announced in court that a settlement has been reached.
David Scoffield QC, appearing with Aiden Corrigan for Mr Paisley, read out a statement agreed with Mr Allister and his barrister Alan Kane QC.
He said: "This matter has been resolved between the parties on the following basis, taking account of the wider interests of unionism at the present time, with the parties also agreeing that no further public comment will be made by any of them concerning this action or its resolution.
"The plaintiff discontinues his action against the defendants and there will be no order for costs between the parties."
Continuing with the statement, Mr Scoffield added: "The defendants accept that all the fees received by the plaintiff for work carried out in the criminal courts were in respect of cases completed prior to his election as MEP.
"The defendants accept that the plaintiff did not personally negotiate with Sinn Fein."
Following the confirmation, Mr Justice Horner praised both sides for reaching a settlement.
He said: "I would like to congratulate the parties and their legal representatives in coming to a solution in what was a difficult and complicated case that would have run for a considerable amount of time and expended a lot of costs."