The Supreme Council of the Armed Forces, which took power when president Hosni Mubarak was ousted in February, agreed to amend the new law to allow political parties to field candidates in the one-third of seats that had previously been reserved for independent candidates, the official MENA agency reported.
The decision came after a meeting between military chief of staff Sami Enan and members of the Democratic Coalition, which groups dozens of political groups, including the powerful Muslim Brotherhood and the liberal Wafd party.
Those at the meeting -- and dozens more groups -- had objected to Article 5, which stipulates that two-thirds of seats would be on a party list system and the rest for independents.
On Thursday they threatened a vote boycott unless the controversial article was cancelled, throwing into question the credibility of Egypt's first post-Mubarak polls.
SCAF has also agreed to examine activating a law that would ban corrupt politicians from running for office for 10 years, and to look into lifting the emergency law, MENA said.
Under the old system, hundreds of candidates ran as independents if they did not make it onto Mubarak's National Democratic Party lists, only to join the party after winning seats.
Candidates affiliated with the ruling party used patronage or pressure to garner votes.
Activists hope that the amendment to the law would prompt voters to elect candidates based on a party programme, circumventing candidates' personal influence.
The political forces meeting with Enan -- who is also the number two on SCAF -- came hours after scuffles and stone-throwing broke out in Tahrir Square as army troops attempted to remove protesters who wanted to stage a sit-in.
On Tuesday, the ruling council laid out the timetable for parliamentary elections which will start on November 28 and take place over four months.
A presidential election is expected to be held next year.
The meeting came a day after thousands flocked to Tahrir to demand an end to military trials of civilians, to call for the cleansing of institutions of former regime remnants, amendment of the electoral law and social justice.
Trouble broke out on Saturday when protesters who said they would stay in the square until their demands are met were removed by security forces and troops, the official MENA news agency reported.
It said several arrests were made after some protesters refused to move and began hurling stones at the security forces. Most groups involved in Friday's rally had said they would not take part in the sit-in.
Around a dozen protesters were arrested on Friday after around 300 tried to head to the defence ministry but were blocked by military police.
SCAF has repeatedly stressed its commitment to democracy but protesters have been gathering in Tahrir on an almost weekly basis to express their anger and frustration at the military's handling of the transition.