The policies typically cost 25 pounds a year and promised to protect people if their card was lost or stolen.
However, fraudulent spending on credit and debit cards is covered by banks unless there is proof that the customer was "grossly negligent" or failed to report the incident within a reasonable time.
Customers were effectively "covered twice", regulators said.
People who claim compensation could receive more than 250 pounds, plus interest, for premiums paid since January 14 2005, the Financial Conduct Authority said.
Letters detailing the rip-off will be sent this week and how to apply for redress, which should be paid later in the year.
Tracey McDermott, a director of the regulator, said 11 major banks had agreed a "simple and free way to claim compensation".
No formal investigation has been conducted as the FCA is relying on customers replying to the letter and claiming compensation for themselves.
Barclays, HSBC, Lloyds Bank, Santander and Royal Bank of Scotland are all implicated, along with major credit card providers such as Capital One.
Each card issuer worked in partnership with a company called Affinion to offer the insurance. Affected customers will have held policies under names such as: Card Protection, Sentinel, Sentinel Gold, Sentinel Protection, Sentinel Excel and Safe and Secure Plus.
Eligible customers will have to vote in favour of the scheme in order to receive their money, as it has to be approved formally by the High Court.
A further letter in April or May will explain how to do this.
The policies mis-sold by banks were almost identical to those run by CPP, for which a compensation scheme is already in operation.
Around seven million people were due an average 200 pounds each having been mis-sold the same type of fraud protection.
Customers paid between 30 pounds and 80 pounds a year for the extra cover, which also claimed to protect against identity theft. The FCA ordered compensation totalling 1.3 billion pounds after deciding the policies were often redundant.
Many customers failed to fill in the forms to apply for compensation and will miss out, according to Martin Lewis, founder of Moneysavingexpert.com.
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