Foreign investors will be allowed to fully own new services in suburban areas, high speed tracks, and connections to ports, mines and power installations, said two senior officials involved in the deliberations.
Existing passenger and freight network operations will not be open to foreign investors under the initiative, which seeks to ease bottlenecks that slow travel on the world's fourth-largest rail system.
"The plan is to allow 100 percent foreign direct investment in suburban corridors, high-speed train systems, freight line projects implemented through public-private partnership," said an official at the Department of Industrial Policy & Promotion.
The government officials said the move could attract up to $10 billion of foreign investment over the next five years.
Previous targets to attract private investment to build India's infrastructure have been missed by a wide margin, but there were positive initial responses from potential investors such as General Electric Co and Bombardier.
Established under British colonial rule, India's vast train network has been overtaken by China's rapid rail expansion over the past two decades.
Indian train travel is very cheap, and transports some 25 million passengers daily. But years of underinvestment mean the service is slow and plagued by frequent accidents, most recently a fire that killed nine people this week.
Freight charges are pegged far higher to subsidise the passenger services, driving much cargo transport onto clogged roads.
In the 66 years since independence, India has added 13,000 km (8,077 miles) of new railway lines bringing the total size to about 64,000 km (39,767 miles).
Only 1,750 km (1,087 miles) of new lines were added by India from 2006 to 2011, compared with 14,000 km (8,699 miles) by China, according to a report by the Ernst & Young.
Consequently, road transport as a share of freight traffic has gone up to about 60 percent in India compared with about 44 percent in the United States and 22 percent in China, government and industry data shows.
The reform, which does not need parliamentary approval, has been agreed by the railways, industry and finance ministries and has been submitted for consideration by the cabinet, which could sign off on it as soon as next week, said one official. Parts of the cabinet note were seen by Reuters.
The plan is one of a series of moves the ruling Congress party hopes will help spur India's economy out of a deep slump ahead of a general election due by May in which it is expected to struggle to hold off the challenge of the opposition BJP.
Railway ministry officials expect interest from Chinese firms such as CSR Corp Ltd, Germany's Siemens, as well as Japanese manufacturers that already work in India as contractors and suppliers to the railways.
The proposal was greeted enthusiastically by Canada's Bombardier, which in 2008 set up a 33 million euros ($44.88 million) factory in Gujarat state to build trains for Delhi Metro and plans exports to other Asian markets.
"Bombardier is bullish about the demand and the future prospects of Indian rail transportation industry," said Harsh Dhingra, chief country representative, Bombardier Transportation.
"Multinational companies from North America, Europe, the U.S. and Japan have shown a long-term commitment to set up a base and invest in India to cater to the future demand in the sector."
India's rail wagon manufacturers were also enthused by the plans and expect to set up joint ventures with foreign players.
"Obviously we will be interested in a joint venture. We are positioning ourselves for that. We expect it will bring very good business opportunity for us as well as for the country," said Sandeep Fuller, the CEO of Texmaco Rail & Engineering Ltd, a Kolkata-based wagon manufacturer.
India has opened industries including retail, civil aviation, pharmaceuticals, telecommunications and defence to foreign investors in recent years, with the goal of improving the nation's finances and driving economic growth.
The liberalisation has had mixed results, with supermarkets especially complaining that red tape, politics and corruption make it difficult to do business in India.
FDI inflows during the April-October period were down 15 percent from a year earlier at $12.6 billion, despite the opening of new sectors.
The involvement of foreign firms in the main rail network is currently restricted to exporting rolling stock, signalling systems and engines to Indian Railways, a state-run behemoth that employs around 1.4 million people.
Trade unions and many political parties oppose allowing foreign investment in railways, and Chinese participation in particular could raise suspicion in security circles. India, which fought a brief war with China in 1962, is cautious about its growing role in the Indian economy.
In the past, the government of Prime Minister Manmohan Singh has backed off liberalisation policies in the face of public and political opposition.
According to local media reports, in October, India rejected bids from two Chinese companies -- CSR Corp and China CNR Corp to set up locomotive plants under the public-private partnership model.
Current policy only allows direct foreign investment in urban metro projects.
Any investors in building track will still have to overcome the administrative hurdles such as project approvals and land disputes that meant investment by private Indian companies in railways has not met government goals.
In the five-year period to April 2012, the railways only saw 4 percent of $16 billion investment targeted through public-private partnerships.
General Electric Co, the world's largest maker of diesel locomotives, said it would prefer a public-private partnership to make locomotives with Indian Railways for new projects, but despite a lot of discussion, "progress has been very slow".
The U.S. company said it would welcome any steps to open India's railways to foreign investment.
"Any fresh impetus to expedite private sector participation on existing project plans, as well as new areas, would be a welcome step in the right direction," said Nalin Jain, South Asian business leader for GE's transportation unit.
GE, which has operated in India since 1902 and has nearly 15,000 employees there, said it has submitted a formal proposal to manufacture locomotives in India and was also trying to sell its train signalling and speed control products for various subway projects around the nation.