The people of Callander say the money will enable the construction of their pioneering low carbon project in the heart of the Loch Lomond and Trossachs National Park.
The scheme aims to generate around 1,300,000 kW hours of energy per year, enough to provide electricity for 300 average homes. Once it is up and running it is expected to deliver up to £2.85 million over 20 years to support community projects.
The project is being backed by finance from Triodos Bank, Scottish Enterprise's investment arm, the Scottish Investment Bank and Social Investment Scotland.
Energy Minister Fergus Ewing announced the funding package, saying: "Our ambition is for all communities across Scotland to share in the rewards of our country's renewable resources.
"This is an important milestone for the community. The money from the project will be reinvested back into the community helping it to become stronger and more sustainable."
While the few hundred people who live on Morvern Peninsula were the first community group to invest their own money in the development of a hydro scheme on Forestry Commission land, the plan had come from the energy developer Green Highland Renewables.
The whole idea of the Callander Community Hydro Ltd (CCHL) came from local people themselves.
Frank Park, Chair of CCHL said: "We are thrilled to be leading the way in community hydro electric projects. This funding allows the construction of the project."