The alliance between Abadi's Victory Alliance, which came third in a May parliamentary election, and Sadr's Saeroon list, which won the largest number of seats, increases the chances of forming a government after weeks of political tensions.
On Saturday, Abadi travelled to the Shia shrine city of Najaf to meet Sadr. After three hours of talks, they issued a joint statement announcing they had set up a coalition.
"We announce a cross-sectarian, cross-ethnic alliance to speed up forming the next government and to agree on common points that guarantee the interests of the Iraqi people," Sadr said at a news conference in the Shia holy city of Najaf.
Sadr presents himself as a non-sectarian nationalist opposed to both the United States and Iran's influence over his country. Saeroon is an electoral alliance between Sadrist politicians, the Iraqi Communist Party, and other secular candidates.
Still, earlier in June Sadr went into an alliance with Hadi al-Amiri, a Shia militia commander with close ties to Iran whose Fatih coalition came second in the election.
There was no immediate reaction from Amiri's camp, but the prime minister said his pact with Sadr would not compromise the cleric's other alliance.
"I affirm that this alliance is not in contrast to any other alliances either of the two lists have previously entered into with other blocs, rather, it flows in the same direction and same principles," Abadi said.
The top three winning blocs, all Shia-led, have upwards of 140 seats between them. At least 165 seats are needed to form a government, although traditionally the ruling bloc in parliament tends to be larger so as to include Sunni Arab and Kurdish lawmakers.
A coalition between Sadr, Amiri, and Abadi could see internal divisions. Abadi had balanced US and Iranian interests during his term and was backed by the West. Sadr says he opposes both, and Amiri is Iran's biggest Iraqi ally.
A source close to Sadr's alliance said the thorniest issue is who will fill the post of prime minister in the new government.
In spite of coming in third, Abadi is hoping to win a second term as a compromise candidate for the premiership. Still, analysts and diplomats say he would be weakened and be beholden to Sadr and Amiri if he manages to stay on.
Abadi and Sadr both called on the leaders of other blocs to meet and "agree on the coming steps" in order to speed up the formation of an inclusive Iraqi government.
The process is further complicated this time around because the next parliament is born of an election marred by historically low turnout and allegations of fraud.
The outgoing parliament has mandated a nationwide manual recount of votes and Iraq's top court upheld that move, which faced legal challenges.
A fire at a storage site housing half of Baghdad's ballot boxes had raised tensions. Security forces said it was deliberate and made arrests, but said most ballots were saved. No party has yet been identified as responsible.
The recount will slow the process as the new parliament and government cannot be formed until the results are officially ratified by Iraq's Supreme Federal Court.
Political leaders need to meet soon in order to end that "crisis" and speed up the process, Abadi said.