Military generals will be able to direct battles and explore disaster zones in real time, which could radically alter the way battles are fought.
Rather than standing on the front line, commanders can order the deployment of troops from a portable command centre small enough to fit inside a briefcase.
The technology will enable generals to see the surroundings for themselves as 3D images pop up on virtual screens showing live footage from drones above the battleground.
In addition, computer-generated advisers are on hand to offer tactical advice.
They system also provides users with interactive gloves resembling those seen in the 2002 film Minority Report, where three mutants foresee all crime before it happens.
BAE Systems and academics at Birmingham University have already built a prototype and it could be introduced within five years.
It is also hoped it could be used to tackle riots and counter terrorist attacks.
The system uses the Oculus ‘Rift’ headset that has been developed for the video games industry.
It is expected to revolutionise the gaming industry when it is introduced next year.
Nick Colosimo, futurist at BAE Systems, said: ‘We’re already seeing virtual and augmented reality becoming more commonplace in consumer products, and the possibilities it offers the armed forces are hugely exciting.
‘Our unique approach will identify the optimal balance between the real world and the virtual – enhancing the user’s situational awareness to provide battle-winning and life-saving tools and insights wherever they may be.’
The same technology has also been used to create a ‘wearable cockpit’ for combat aircraft that could be in use within a decade.
This would see augmented images replace physical images and controls in combat aircraft.
Professor Bob Stone, simulation and human factors specialist at the University of Birmingham said: ‘Being able to physically manipulate virtual objects in the real world has been challenging scientists for 40 years.
‘Since my first virtual reality experience at NASA nearly 30 years ago, the technology has evolved from the primitive head-mounted displays and computers to today’s world where we can interact with complex virtual objects, integrated in real-time with real-world scenarios
BAE said headsets could be replaced within 20 years by contact lenses that would project the 3D images and information screens directly in front of their eyes.