AIG will get an $85bn loan, in return for an 80% public stake in the firm.
The rescue follows the collapse of US investment giant Lehman Brothers, which caused share prices to plummet across the world's financial markets.
Meanwhile, Barclays said it had reached a deal to buy Lehman's US investment banking and capital markets businesses.
The $250m deal, which is subject to approval from the bankruptcy court, will make the British bank the third biggest investment bank in the US.
Barclays will also purchase Lehman's New York headquarters and its two data centres in New Jersey for $1.5bn.
Emergency meeting
The rescue of AIG - which has a trillion dollars in assets and insures bank loans around the world - prompted a tentative rally on Asian markets.
Wednesday trading saw gains in Tokyo, Taiwan, Singapore and Seoul, though prices in Hong Kong fell after starting higher.
The dollar also rose against major currencies.
The board of the Federal Reserve made its decision about AIG "with the full support of the Treasury Department", it said in a statement, adding that the secured loan included conditions designed to protect "the interests of the US government and taxpayers".
US Treasury Secretary Henry Paulson refused to bail out Lehman Brothers, the fourth-largest investment bank in the US, after it filed for bankruptcy protection on Monday.
However, Mr Paulson said he supported the Fed's move to assist AIG and said the move would protect taxpayers.
"These are challenging times for our financial markets," he said.
Correspondents say the demise of AIG - which has policy holders in more than 100 countries and insures deals and investments across the globe - would have a far greater impact on financial markets than Lehman's collapse.
Were the company to fail, many banks and investment funds in the US and around the world would lose their insurance cover at a time when defaults on payments are likely to rise.
The Governor of New York, David Paterson, said AIG had so many business interests it would be hard to predict how widespread its bankruptcy would have been felt.
"Its tentacles go further in to the avenues of business, as in mortgages, as in credit, as in hedge funds, as in countless ways that affect consumers, that affect drivers, that affect homeowners, affect passengers," he said.
AIG had posted losses in each of the last nine months.
It was badly affected by the collapse of the US housing market, says the BBC's business reporter Rob Young, owing to the underwriting payments it was forced to make when customers defaulted on their loans.
Market slump
The AIG plan calls for the government to seize up to 80% of the company and remove its management, in a similar fashion to the way it took control of mortgage giants Fannie Mae and Freddie Mac which were crippled by the US housing crisis.
The White House welcomed the package, saying the deal was made "in the interest of promoting stability in financial markets and limiting damage to the broader economy".
Meanwhile, the Fed has left interest rates unchanged at 2%. The BBC's Matthew Price in New York said the bank had decided an interest rate cut would not help to alleviate the short-term financial crisis.
On Wall Street, the Dow Jones rallied on Tuesday, closing 141 points higher having on Monday suffered its worst day's trading since the September 2001 attacks on the US.
But leading indices across Europe ended lower, with banking shares being the worst hit.
Central banks around the world responded by carrying out emergency measures to keep markets liquid.
The Bank Of England and the Bank of Japan injected £20bn (25bn euros; $36bn) and 2.5 trillion yen ($24.1bn; £13bn) respectively into their money markets.
The extra funding came as the interest rates at which banks lend to each other rocketed - as they did at the start of the credit crunch. AIG - KEY FACTSEmploys 116,000 people in more than 100 countriesEmploys more than 2,000 people in the UKFounded in 1919 in ShanghaiNow based in New YorkSponsors Manchester UnitedSells insurance policies through Argos and BootsSource: AIG
