The U.S. Court of Appeals for the 11th Circuit, based in Atlanta, halted the controversial provision that permits Alabama to require public schools to determine the legal residency of children upon enrollment.
The court also blocked a provision that made failing to carry documents proving legal residency status a misdemeanor crime.
But the court ruled the state could continue to authorize police to detain people suspected of being in the country illegally if they cannot produce proper documentation when stopped for any reason.
The Obama administration and a coalition of civil rights groups had sought to stop the law while it was under court review, arguing it has led some illegal immigrants in Alabama to pull their children out of school and even flee the state.
The Justice Department also contends the measure, passed by large margins in both chambers of the Republican-led legislature earlier this year, interferes with the federal government's exclusive authority over immigration.
State lawmakers argue they were forced to act, saying the Obama administration had not done enough to stem the flow of illegal immigrants into the country.
Under the ruling issued on Friday, Alabama can bar illegal immigrants from entering into commercial contracts with the state or local governments and applying for or renewing drivers' licenses, identification cards or license plates.
"Once again, we're pleased that the majority and most effectual parts of this law will remain in place," said Alabama House Speaker Mike Hubbard, a Republican.
"While the federal government sues to prolong and exacerbate the illegal immigration problem, Alabama is taking action to ensure the laws of our land are upheld."
LAWYERS MONITORING ALABAMA
The Justice Department said it looked forward to the appeals court giving further consideration to its arguments for blocking other key provisions of the law.
"We are pleased that the Eleventh Circuit has blocked Alabama's registration provisions which criminalized unlawful presence and chilled access to a public education," the department said in a statement.
Federal judges have previously blocked key parts of other immigration laws passed in Georgia, Arizona, Utah and Indiana.
The Justice Department has stationed four lawyers in Alabama to watch for civil rights violations and hate crimes, Assistant Attorney General Thomas Perez told reporters in Birmingham on Friday.
Perez, who leads the department's Civil Rights Division, said they are monitoring "troubling data" stemming from anecdotal reports of children getting bullied and crime victims being unwilling to come forward.
"We are trying to track down information to separate fact from fiction," said Perez.
Malissa Valdes, spokeswoman for the Alabama Department of Education, said 1,250 Hispanic students were reported absent on Thursday, down from a spike of 5,143 out on Wednesday as part of a statewide boycott of services and commerce by the Hispanic community.
The day before the law took effect last month, 1,064 Hispanic students were reported absent, Valdes said.
Carla Gonzales said she and her children have been under a self-imposed house arrest in Mobile since a federal judge had upheld the bulk of the state's strict anti-illegal immigration law on September 28.
She and others in the immigrant community said they felt some relief following Friday's ruling.
"We can go to church again and not look over our shoulder when we go buy groceries. I'm thrilled," she said.
Stockton resident Garrett Harrison, who owns a handyman business, said he hopes the law ultimately remains intact but sees no problem with the court holding off on enforcing the portions that affect children until a final review is completed.
"I think a lot of what we're hearing is panic, and if (immigrants are) here illegally they should be scared, but I don't see any reason to drag children into something that's not even sorted out yet," Harrison said.