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Kennedy's departure at the end of July will give Trump the opportunity to appoint his second justice to the nine-seat bench, which exerts a deep and far-reaching influence on American life.
"It has been the greatest honor and privilege to serve our nation in the federal judiciary for 43 years, 30 of those on the Supreme Court," Kennedy was quoted as saying in a statement announcing his decision.
Nominated by president Ronald Reagan, the 81-year-old Kennedy took his oath of office in 1988.
He said his decision to step aside was based on his deep desire to spend more time with his family.
Paying tribute to Kennedy as "a great justice of the Supreme Court," Trump told reporters the replacement process will "begin immediately."
"Hopefully we will pick someone who is just as outstanding," he told reporters in the Oval Office.
He said Kennedy's successor would be selected from among a list of 25 possible candidates -- 20 identified during his presidential campaign, and five added since.
"We have a very excellent list of great, talented, highly intelligent, hopefully tremendous people," he said.
In a statement the White House said that "Justice Kennedy has been a tireless voice for individual rights and the Founders' enduring vision of limited government. His words have left an indelible mark not only on this generation, but on the fabric of American history."
Kennedy's vote, positioned at the very center of the court, gave him a place of special prominence among the nine justices.
He has cast the deciding vote in a number of historic cases, including the high court's groundbreaking decision in 2015 legalizing gay marriage, a five-to-four decision for which he wrote the opinion.
- Infuriated liberals, exasperated conservatives -
For years, Kennedy has infuriated conservatives with decisions striking down prayer at public school graduations and upholding abortion rights -- and exasperated liberals with decisions on affirmative action and campaign finance laws.
His departure gives Trump his second Supreme Court pick since arriving at the White House, following the nomination of Neil Gorsuch, and could spell a decisive shift to the right for the top judicial body.
Gorsuch was sworn in in April last year to fill a more than year-long vacancy left by the death of conservative justice Antonin Scalia.
That delay, orchestrated by Republican Senate majority leader Mitch McConnell, took the nomination away from then-president Obama and handed it to the newly elected Trump. Democrats were enraged, but with Republicans controlling both the Senate and the House, they have limited leverage to push back over Trump's second pick for the court.
Control over Supreme Court nominations has become a hot-button issue for the US electorate, with 70 percent of respondents in a 2016 CNN poll saying it was an important factor in their vote.
November's mid-term elections are expected to produce a bitter struggle for control of Congress in a deeply polarized country, especially if a court seat is still in play.
Gorsuch's influence has already been felt in a series of recent court decisions that have backed a modified version of the president's travel ban on visitors from Muslim-majority countries, bolstered anti-abortion activists and dealt a serious blow to labor unions.
If Trump, as expected, nominates a steadfast conservative to the bench, that shift is likely to become entrenched for years to come.
Chuck Grassley, the Republican head of the Senate judiciary committee, said Kennedy "set an example of integrity and wisdom that I hope all jurists will emulate."
"I expect the President will soon nominate someone for the Senate to consider. I encourage the President to choose a nominee with the credentials, intellect and commitment to the rule of law necessary to serve on the Supreme Court," he said in a statement.
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