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 Bhutto's party threatened to withdraw its lawmakers from Parliament unless "steps for national reconciliation" are taken.
Monday's announcement by government attorney Sharifuddin Pirzada was the first clear official statement that Musharraf is ready to end direct military rule, eight years after he seized power in a bloodless coup.
Musharraf plans to win a new five-year term in a vote by all federal and provincial lawmakers due by Oct. 15, a month before the end of his current term.
However, his authority has waned in recent months after a failed attempt to sack the Supreme Court's top judge, and the opposition insists that the U.S.-allied general is ineligible to continue as head of state.
He also faces a wave of violence blamed on Taliban and al-Qaida militants that has intensified popular discontent with his alliance with Washington.
Pirzada announced Musharraf's intentions in the Supreme Court as judges heard petitions challenging his dual role as president and army chief and his eligibility for the presidential vote.
"If elected for the second term as president, Gen. Pervez Musharraf shall relinquish charge of the office of the chief of army staff soon after election, but before taking the oath of office of the president of Pakistan for the next term," Pirzada said.
Mushahid Hussain, secretary general of ruling Pakistan Muslim League-Q party, forecast that Musharraf's decision about his military role "will lower the political temperature and it will deprive the opposition of a major contentious issue."
"It divided the Pakistan polity. It had undermined Pakistan's international image because people said you don't have full democracy. I think we have moved on," Hussain told reporters on the steps of the court.
However, opponents said they would continue their campaign against Musharraf's continued rule.
"He is blackmailing. This is a threat from him. He is saying that first you elect me as the president and then I will quit as the army chief," said Zafar Ali Shah, a leader of the party of Nawaz Sharif, who was ousted as prime minister in the 1999 coup.
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 Authorities sent Sharif back into exile in Saudi Arabia when he tried to return last week to campaign against Musharraf.
Opposition parties are challenging the legality of Musharraf's re-election, including a rule change announced Monday by the Election Commission apparently opening the way for the general to seek a new term without resigning from the army first.
For months Musharraf has been negotiating with Bhutto over a possible power-sharing deal, but negotiations have snagged amid opposition from right-wingers in the ruling party who could be eclipsed if Bhutto makes a triumphant return, which she plans to do on Oct. 18.
"Gen. Musharraf's decision to get himself re-elected in uniform is both unconstitutional and undemocratic," party information secretary Sherry Rehman said.
Rehman said the party's lawmakers might resign in protest -- a move that other opposition parties have vowed to take in order to deny Musharraf legitimacy
-- unless the government dropped corruption cases against Bhutto and other politicians and let her run for a third term as prime minister.
"If these steps for national reconciliation are not taken, the Pakistan People's Party will consider resigning from the Parliament," Rehman said.
[Associated Press; by Sadaqat Jan]
Associated Press Writer Stephen Graham contributed to this report.
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