Citigroup agreed Thursday to massive settlement with regulators that requires the bank to repurchase almost $20 billion of troubled auction-rate securities and pay millions in fines.

The agreement comes as banks and brokerages that sold auction-rate securities have come under scrutiny for telling investors that they were highly liquid “cash equivalents.” The $330 billion market has been virtually frozen since February.

As part of the settlement, which was reached with the Securities and Exchange Commission, the New York Attorney General and other state regulators, Citigroup has agreed to buy back, at par, $7.5 billion in auction rate securities that it sold to individual investors, small businesses and charities. Further, the bank has promised to use its “best efforts” to liquidate another $12 billion of auction-rate securities sold to retirement plans and institutional investors by the end of 2009.

“Today’s agreement in principle provides real relief to investors. In a short period of time, about 38,000 individual, small business, and charitable organization investor accounts will receive nearly $7.5 billion in liquidity,” said Linda Chatman Thomsen, Director of the SEC’s Division of Enforcement.

Auction-rate securities are long-term bonds and preferred stocks that resemble short-term instruments because their interest rates are reset periodically —usually every 7, 28, 35, or 49 days. The rate is reset by a modified Dutch-auction process, and because investors are supposed to be able to buy and sell the securities so frequently, they have been generally regarded as equivalent to cash.

“We remain committed to continuing our work on initiatives that will secure the best and fastest route to providing liquidity to our clients,” Citigroup said in a statement.

Citigroup will also pay a $50 million fine to the State of New York and a $50 million fine to other state regulators, although it neither admits nor denies any wrongdoing. New York Attorney General Andrew Cuomo, who aggressively pursued “misrepresentations” in the marketing of auction-rate securities, called the settlement a “resounding message” to the auction-rate securities industry.

“This type of deceptive behavior will not be tolerated and we will actively seek justice on behalf of investors in auction rate securities,” said Cuomo. “Our goal is simple: to get investors back their money, and that’s exactly what this deal does.”

Citigroup also has agreed to an arbitration process to resolve claims by retail investors seeking damages as a result of not being able to access their funds. It will also reimburse individual investors who sold their auction-rate securities at discounts on secondary markets after the auctions failed.

“This has been a very positive event for the retail holders,” says Barry Silbert, CEO of Restricted Securities Trading Network (RSTN), which started a secondary market for auction-rate securities in March. “It will likely result in other banks reaching similar settlements.”

UBS, a Swiss bank, has been in talks with Cuomo and the SEC. It previously agreed to buy back $3.5 billion in auction-rate securities from its customers and to pay $41.3 million to settle allegations by the Massachusetts attorney general. Also on Thursday, Morgan Stanley agreed to pay the state of Massachusetts $1.5 million for misleading the towns of New Bedford and Hopkinton into investing in auction-rate securities.

Silbert says that his exchange is already seeing an uptick in transactions, as sellers are more willing to take higher discounts on auction-rate securities, with the knowledge that more banks may soon be willing to make up the difference.

Pluris Valuation Advisors and RSTN have taken data from transactions on the network’s electronic market and calculate the current “fair value” of the securities. According to a review of 460 auction-rate holders that made public filings by the end of last month, 281 have taken write-downs worth a total of $2.11 billion. Moreover, of 179 companies that have not yet filed their second quarter reports, Pluris expects 100 to take impairments this month. The average impairment is 12 percent.

Some wondered how Citigroup, which lost $2.2 billion in second quarter, will be able to afford such a massive payout. The agreement stipulates that the bank will not be able to liquidate its own holdings of auction-rate securities until it liquidates those of its customers.

“I don’t see Citigroup, in its present financial malaise, being able to keep this stuff on its balance sheet,” says Harry Newton, an investment guru who has started the blog AuctionRatePreferreds.org for rants from angry auction-rate investors. “Clearly they knew the stuff was toxic.”