Undersecretary of State Sarah Sewall denied political considerations came into play in the ratings.
The "Trafficking in Persons" report, one of several annual assessments issued by the department on human-rights-related topics, is unusual in that it rates nations, which can ruffle diplomatic feathers. It is based on the actions governments take, rather than on the scale of the problem in their countries.
Globally, more than 20 million people are believed to be affected in industries such as mining, construction, the sex trade and domestic service.
Critics contend that Malaysia's upgrade is related to its participation in the Trans-Pacific Partnership, a U.S.-backed trade agreement among Pacific Rim countries and a key economic element of President Barack Obama's Asia policy. An anti-trafficking amendment to legislation crucial for the deal's ratification by Congress would limit his ability to secure free trade agreements with countries assigned to tier 3.
Thailand, downgraded with Malaysia last year because of pervasive labor abuses in its lucrative fishing industry, remains on the list. Thailand is not a party to the proposed agreement.
Obama now has 90 days to determine whether to apply sanctions against tier 3 governments. The president can block various types of aid and could withdraw U.S. support for loans from the World Bank and International Monetary Fund. But the U.S. often chooses not to, on the basis of its national security interests, as it did last year for Thailand and Malaysia, which Washington views as important partners in its strategic outreach to Asia.
Among the 23 nations that remain on tier 3 are Iran, Libya, North Korea, Russia, Syria and Zimbabwe.
Uzbekistan was upgraded after two years on the list. The State Department cited a government prohibition on forced labor of children in the 2014 cotton harvest, although it said government-compelled use of adults in the harvest remained "endemic."
Other nations upgraded from tier 3 were the Democratic Republic of Congo, Papua New Guinea and Saudi Arabia. Those downgraded to tier 3 were Belarus, Belize, Burundi, Comoros, the Marshall Islands and South Sudan.
Malaysia's upgrade is likely to raise the most hackles in Congress and among human rights activists. Earlier this month 19 U.S. senators wrote to Secretary of State John Kerry urging that Malaysia stay on the list; 160 House members also registered concern, arguing that an upgrade would not be merited and would appear driven by "external considerations."
Malaysia is one of 12 nations negotiating the Trans-Pacific Partnership. The nations' trade ministers are meeting in Hawaii this week, hoping to close on the agreement after years of talks. Malaysia's human trafficking upgrade has angered advocates who argue the U.S. favors financial benefits over human rights.
Like Thailand, Malaysia has faced intense international criticism over trafficking of stateless Rohingya Muslims from Myanmar and Bangladesh aboard overcrowded boats. Dozens of graves as well as pens likely used as cages for migrants have been found in abandoned jungle camps on both sides of the Thailand-Malaysia border.
"By upgrading Malaysia, the U.S. is selling out victims of human trafficking," said Melysa Sperber, the director of the Alliance to End Slavery and Trafficking. "It also undermines the integrity of the report and jeopardizes the credibility that has been built up over many years."
The Thai Embassy in Washington "strongly disagreed" with its retention on tier 3. It said in a statement the evaluation "does not accurately reflect the reality and fails to take into account significant efforts undertaken by the Thai government on all fronts during the past year."
Al Jazeera and The Associated Press