Pedro Hernandez, 51, was arrested on Wednesday following a tip off to police about the disappearance in Manhattan in May, 1979.
It is the first arrest to be made in America's most notorious missing child case.
Investigators said Hernandez confessed to intercepting Etan, 6, on his way to a school bus stop, before luring the little boy to his Soho shop with the offer of a soft drink.
He then allegedly strangled him in the basement before throwing his body out with the rubbish.
It was the first time Etan's parents had let him make the journey from his family home to the bus stop alone.
His disappearance came to symbolise the plight of missing children across the US, and his face was the first to be printed on the side of milk cartons as part of a national effort to find him.
But the boy's body has never been found, despite hundreds of leads over three decades and investigators have admitted that even with this latest development he may never be recovered.
Just last month, police spent four days digging up a basement in Soho on the same street where Etan disappeared, but found nothing.
Etan's parents still live nearby, reportedly afraid to change their phone number or move away in case their son tried to contact them.
It is thought the search in April jogged memories among relatives of Hernandez, and prompted the tip-off.
After extensive interviews on Wednesday and Thursday, police revealed Hernandez told family members many years ago that he had done something bad and killed a boy in New York, but until now the former construction worker had never been interviewed in connection with the case.
According to police Hernandez seemed "remorseful", and was formally charged with second-degree murder from his hospital bed, where he is undergoing psychiatric evaluation.
No motive has been given for the alleged crime.