Transport secretary Geoff Hoon this morning said the Department for Transport would be giving Transport for London (TfL) £64M to undertake the project.
"The ELL extension will deliver a key rail link south of the river and improve local transport for Londoners," said Hoon.
Work is currently underway to complete the £1bn East London Line extension from Dalston in north east London to Crystal Palace and West Croydon in the south of the capital by 2010, with a further extension north to Highbury and Islington completed in 2011.
Phase 2, confirmed today, would create an east-west spur from Surrey Quays to Clapham Junction.
At Clapham Junction trains would then be able to run on to the London Overground services to Highbury and Islington, completing a circuit of Central London around zones 2 and 3.
"We can finally get cracking on a vital section of track that will orbitise our overground rail services," said London mayor Boris Johnson.
The new extension would create a new line to link the following stations, with four trains per hour in both directions:
Clapham High Street
Queen's Road Peckham
- Surrey Quays
The proposed station at Surrey Canal Road has been put on hold, but the line will be designed with an eye to building this station in the future.