The Corrections chief executive would consider each request for a transfer on a case-by-case basis, and the policy would not apply to transgender prisoners with a record of serious sexual offences.
At present, there are nine transgender inmates in New Zealand jails.
Mrs Tolley also announced that all remand prisoners would no longer be automatically classed as high-risk.
Low-risk inmates would have a "less restrictive", individual security classification, which would allow them to get better access to rehabilitation programmes.
The Government has expanded its drug, alcohol and education programmes in an attempt to meet an ambitious goal of reducing reoffending by 25 per cent by 2017.
Green Party rainbow issues spokeswoman Jan Logie said the rule change was a "huge win" for transgender prisoners which would keep them safe from sexual assault and rape.
"I congratulate the Minister and the Government for taking another step towards making sure transsexual and transgendered people have the rights they deserve."