Alice Munro, 82, whose books include Dear Life and Dance of the Happy Shades, is only the 13th woman to win the prize since its inception in 1901.
Previous winners include literary giants such as Rudyard Kipling, Toni Morrison and Ernest Hemingway.
Presented by the Nobel Foundation, the award – which is presented to a living writer – is worth 8 million kronor.
Last year’s recipient was Chinese novelist Mo Yan.
Alice Munro, who began writing in her teenage years, published her first story, The Dimensions of a Shadow, in 1950.
She had been studying English at the University of Western Ontario at the time.
Dance of the Happy Shades, published in 1968, was Alice Munro’s first collection, and it went on to win Canada’s highest literary prize, the Governor General’s Award.
In 2009, Alice Munro won the Man Booker International Prize for her entire body of work.
Alice Munro is the first Canadian writer to receive the prestigious award since Saul Bellow, who won in 1976.
Often compared to Anton Chekhov, Alice Munro is known for writing about the human spirit and a regular theme of her work is the dilemma faced by young girls growing up and coming to terms with living in a small town.
The Nobel academy praised her “finely tuned storytelling, which is characterized by clarity and psychological realism”.
Since the 1960s, Alice Munro has published more than a dozen collections of short stories.
Her early stories capture the difference between her own experiences growing up in Wingham, a conservative Canadian town west of Toronto, and her life after the social revolution of the 1960s.
In an interview in 2003, Alice Munro described the 1960s as “wonderful”.
It was “because, having been born in 1931, I was a little old, but not too old, and women like me after a couple of years were wearing miniskirts and prancing around,” she said.
Alice Munro’s writing has brought her several awards. She won a National Book Critics Circle prize for Hateship, Friendship, Courtship, Loveship, Marriage, and is a three-time winner of the Governor General’s prize and The Commonwealth Writers’ Prize.
Other notable books include Lives of Girls and Women, Who Do You Think You Are, The Progress of Love and Runaway.
In 1980, The Beggar Maid was shortlisted for the annual Booker Prize for Fiction and her stories frequently appear in publications such as the New Yorker and the Paris Review.
Several of her stories have also been adapted for the screen, including The Bear Came Over the Mountain, which became Away from Her, starring Julie Christie and Gordon Pinsent.
Alice Munro revealed earlier this year that her latest book, Dear Life, published in 2012, would be her last.
In 2009, Alice Munro revealed she had been receiving treatment for cancer. She also had bypass surgery for a heart condition.
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