The advance came as Libya's parliament again failed to vote on a UN-backed unity government seen as a crucial step in ending years of political chaos and conflict in the North African state.
Special forces retook the Benghazi area of Lithi, which had been a stronghold for extremist fighters including the Islamic State group, after days of fierce clashes.
Fadel al-Hassi of Libya's special forces said the neighbourhood was "totally liberated".
Libya has had rival administrations since the summer of 2014 when the recognised government fled Tripoli after the Fajr Libya militia alliance including Islamists overran the capital.
A power vacuum since the 2011 toppling of dictator Moamer Kadhafi has fostered the rise of IS, which is currently headquartered in the former dictator's hometown of Sirte, but control of Benghazi remains divided between a collection of militias.
Fighting has flared periodically in Benghazi as security forces try to wrest neighbourhoods from armed groups including IS and Ansar al-Sharia, which is close to Al-Qaeda.
Lithi had become notorious as a jihadist nerve centre, dubbed by locals as "Benghazi's Kandahar" -- a reference to the Afghan province that has seen some of the worst insurgent attacks since the US invasion of 2001.
Residents celebrated alongside loyalist fighters, some flashing victory signs next to the bombed-out shells of buildings while others fired celebratory shots into the air.
Some residents also drove into Lithi honking their horns and flashing their lights after security forces allowed them to assess the damage to their homes.
"Today we came back to our house, after a long time, almost one year," one resident said, adding that his family would not be able to move back immediately because their house was damaged.
Army chief General Khalifa Haftar, who spearheaded the Benghazi battle, issued a video statement praising the latest breakthrough which he said was the fruit of "much patience".
- Italy-US drone plan -
Libya's conflict has alarmed Western governments over the prospect of extremist groups including IS establishing a bridgehead just 300 kilometres (190 miles) from Europe.
Italy said on Tuesday it had given the US permission to use an airbase in Sicily to launch drone strikes against IS in Libya.
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Defence minister Roberta Pinotti told the daily Il Messaggero that any strike would be subject to an individual authorisation request to the Italian government and that they would only be used as a "last resort".
US warplanes flying from a Royal Air Force base in Britain attacked an IS training camp in the western Libyan city of Sabratha last week, killing more than 40 people including two Serbian diplomats being held hostage.
On Tuesday, a group of fighters loyal to Fajr Libya battled IS extremists near Sabratha, the city's mayor Hussein al-Dawadi said, adding that four of the fighters were killed in the clashes.
Meanwhile, the internationally recognised parliament based in the eastern town of Tobruk failed to hold a vote of confidence in a new, UN-brokered unity government because it lacked a quorum.
"The required quorum (89 members of parliament) was not reached, so the president of the chamber adjourned the session," MP Mohamed al-Abbani told AFP.
Lawmaker Ali Al-Qaidi said a new session would be held next week.
- Loyalist gains -
UN envoy Martin Kobler voiced his disappointment at the postponement.
"Concerned by slowness of (political) process in Libya, overtaken by military events, must speed up to stop Da'esh expansion," Kobler tweeted, using the Arabic acronym for IS.
After launching a major Benghazi offensive at the weekend, loyalists seized Al-Marayseh port in the west of the city, as well as three army bases that had been overrun by Islamist fighters in its southern and southeastern regions.
Medical sources in Benghazi said that more than 20 loyalist fighters have died since the assault began.
The foreign ministry in Tripoli, home to the unrecognised government, denounced the Benghazi military operations as "unjustified" and an obstacle to peace.
Black smoke could be seen rising in Benghazi while many buildings bore the impact of bullets and rockets and rubble was strewn in the streets.
Lieutenant Ali el-Jeroushi, on the side of the loyalists, pointed out Islamic slogans scrawled on the facades of some buildings, including one reading "the Islamic State is here and spreading".
In the coastal city of Derna, 300 kilometres east of Benghazi, six fighters died in clashes with IS, a local official told AFP, adding that a senior member of the jihadist group was also killed.