Keeping the momentum going from its inspiring run to the 2016 European Championship quarterfinals, Iceland topped Europe Group I and advanced automatically to the finals in Russia next year at the expense of favourite Croatia.
Iceland is the smallest nation in terms of population - 330,000 - to make the World Cup. The previous smallest country to have reached the finals was Trinidad & Tobago in 2006, with 1.3 million people.
Gylfi Sigurdsson put the hosts ahead in in the first half and Johann Gudmundsson made it 2-0 in the second.
Iceland won the group by two points from star-studded Croatia, which beat Ukraine 2-0 in Kiev.
Elsewhere, Ireland stunned Wales 1-0 to seal a spot in the playoffs.
With Serbia winning 1-0 over Georgia to top Group D, the showdown in Cardiff was for the prize of a playoff berth in November.
Ireland took it, thanks to James McClean's 57th-minute goal following a defensive mix-up by the Welsh as an injured Gareth Bale watched on from the stands after missing the key fixture because of injury.
The Irish are looking to qualify for the World Cup for a fourth time, and first since 2002. They will not be seeded in the playoffs draw, which takes place on Wednesday.
Photo by: UMIT BEKTAS/REUTERS (Caption: Iceland is the smallest nation in terms of population - 330,000 - to make the World Cup)