The music industry has been desperate to boost digital sales in recent years to overcome online piracy, and the agreement comes a day before a British report sets out how the creative and telecoms industries should tackle the problem.
People familiar with the service said it would cost 10-15 pounds ($16.30-$24.50) per month, which could appeal to parents concerned by children accessing illegal sites.
The service, which both sides described as a world first, would allow Virgin Media broadband customers to both listen by streaming and download to keep as many music tracks and albums as they want from Universal's catalog.
The music will be in the MP3 format, meaning it can be played on the vast majority of music devices, including the iPod and mobile phones.
The service, which would compete with Apple's iTunes, is set to launch later this year.
Virgin said as part of its cooperation with the music industry it would also work to prevent piracy on its network by educating users and would, as a last resort for persistent offenders, suspend Internet access.
Virgin said no customers would be permanently disconnected.
Jupiter analyst Mark Mulligan said the service went further than both sides of the industry could have hoped, with Virgin agreeing to disconnect offenders, and Universal providing unlimited MP3 music without unpopular anti-piracy software.
"This really is high stakes, if this can't work then what will," he said.
The international music trade body IFPI welcomed the deal.
"This is the kind of partnership between a music company and an Internet service provider that is going to shape the future for the music business internationally," chairman and chief executive John Kennedy said.
"It also marks new ground in ISPs' willingness to take steps to protect copyrighted content on their networks, and that sets a very encouraging example to the whole industry."
Vivendi's Universal Music Group has often led the way in signing such deals.
It has agreed an online subscription music service with Britain's largest pay-TV firm BSkyB, at a range of pricing levels, and was one of the first to sign up to mobile handset maker Nokia's Comes With Music offering.
Screen Digest analyst Dan Cryan said Virgin would need to sign up other labels and noted it would be competing with other free streaming services, which could be difficult.
Virgin said it was also in talks with other major and independent music labels and publishers to offer a complete catalog by the time it launches.
"We see this as completely ground breaking," Universal Music chairman and chief executive Lucian Grainge told reporters.
"We've listened to our customers, our fans and our artists and we think that this is an opportunity to bring music to a wider audience."
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