Speaking during a visit to communist Vietnam and talks with its leaders, Mr Obama said the move removed a "lingering vestige of the Cold War".
The US is trying to bolster its relationship with its Pacific allies, as China asserts territorial claims.
But Mr Obama said the embargo decision was not related to US policy on China.
"It's based on our desire to complete what has been a lengthy process of moving towards normalisation with Vietnam," he said in Hanoi.
Vietnam is one of several countries in the region involved in maritime disputes with China. The US insists on the right to freedom of navigation in the South China Sea.
In 2014, a row over a Chinese oil rig near the Paracel islands led to clashes between Chinese and Vietnamese vessels and anti-China riots in Vietnam.
Why Vietnam wants US weapons
Beijing's new South China Sea islands
High hopes for Obama visit
White House officials had indicated the arms ban, in force since 1984, would be lifted only if human rights in Vietnam improved.
"Sales will need to still meet strict requirements, including those related to human rights, but this change will ensure that Vietnam has access to the equipment it needs to defend itself," Mr Obama said after talks with President Tran Dai Quang.
Vietnam had been arguing for an end to the embargo, which was partially lifted in 2014.
President Obama's easing of all remaining restrictions on arms sales to Vietnam is powerfully symbolic. But what does it mean in practice?
Up to now, Vietnam has relied on Russia to supply most of its defence equipment, a legacy of the Cold War, when they were allies. The government would certainly like to diversify its sources, and is looking at a number of potential alternative suppliers. But it won't be rushing into the arms of US manufacturers just yet.
One reason is that a lot of US technology may be too sophisticated and expensive for Vietnam's needs. And while Vietnam's defence spending, which has doubled over the past decade, is driven by the rivalry with its giant neighbour China, it will not want to antagonise China by seeking state-of-the-art US weapons that might alter the military balance.
Another reason is the complicated process of procuring US weapons. In his announcement, Mr Obama said any military contracts would still be subject to provisos on human rights, and given the Vietnamese government's poor human rights record that might hold up possible arms sales in Congress.
The greatest potential for US sales probably lies in areas like military surveillance systems and coastal defence. Vietnam would welcome technology that helps it track Chinese naval forces. The partial lifting of the embargo two years ago was with the specific aim of improving US sales in this area, yet Vietnam is taking its time to decide what it most wants to buy.
Mr Obama's visit comes 41 years after the end of the Vietnam War in which the US sought to prevent a communist takeover of South Vietnam.
Several million Vietnamese - civilians, communist fighters and South Vietnamese soldiers - were killed, as well as more than 58,000 US soldiers.
By the end of the war in 1975, the communists had gained control of the entire country.
While in Vietnam, Mr Obama is expected to meet dissidents and make the case for Vietnam to remove obstacles to the US-led Trans Pacific Partnership (TPP) free trade deal.
Amnesty International on Monday accused Vietnamese authorities of "carrying out their repressive business as usual" in arresting six activists.
"Before leaving Vietnam, President Obama must insist on the release of all prisoners of conscience," said its international advocacy director, T Kumar.
In a separate move, Vietnamese officials have removed the accreditation of the BBC's Jonathan Head in Hanoi after accusing him of conducting an unauthorised interview - something he denies.
The US president flies later to Japan for a summit of the G7 industrialised nations. His visit will include a tour of Hiroshima, where the world's first nuclear attack was carried out in 1945 by the US, killing at least 140,000 people.
The lifting of the US arms embargo "will tighten the strategic pressure on China", Vietnamese Communist Youth Union newspaper Tuoi Tre says on its website.
"It will also provide Vietnam with leverage in future arms deals with traditional weapons suppliers, particularly its long-time security patron, Russia," the paper says.
China's privately-owned portal Sina News sounds a note of alarm, saying that the lifting of the arms embargo "is a cause for concern" because it may have an impact on territorial disputes in the South China Sea.
A commentary (in Chinese) by Phoenix TV's news anchor Cheng Helin on Sina's "Headlines Blog" argues that Vietnam is being drawn into "co-operation to contain China" as part of "a three-way alliance with the US and Japan". But, says the author, the US is unlikely to sell Vietnam sophisticated weapons.
BBC Monitoring reports and analyses news from TV, radio, web and print media around the world. You can follow BBC Monitoring on Twitter and Facebook.
President Barack Obama has announced the US is fully lifting its embargo on sales of lethal weapons to Vietnam, its one-time enemy.