In this work, a novel application of Active Magnetic Bearing (AMB) is proposed to integrate AMB in the Magnetically Coupled Thruster (MCT) assembly for underwater application. In this study, a 2-Degree-Of-Freedom (DOF) AMB is developed and investigated for the MCT of an Unmanned Underwater Vehicle (UUV). The paper presents the detailed electro-mechanical modeling of the in-house developed AMB system. The intractable problem of rotor suspension and rotation with opposing pairs of electromagnets is considered. A Linear Quadratic Gaussian (LQG) controller is designed and analyzed in the frequency domain for the stabilization of the open-loop unstable AMB for MCT. The performance specifications of the controller, such as reference tracking and disturbance rejection are achieved and evaluated through real-time implementation of the controller. The compensator also performed reasonably well during the dynamic operations, i.e., when the rotor-propeller assembly was spun at 1500 rpm. This rotor speed is needed to generate a thrust of 40–45 N and up to 1 m/s forward velocity, which is necessary to propel the UUV under consideration. By deploying AMB in MCT assembly, it is anticipated that problems associated with the conventional directly coupled thruster operating in harsh underwater environment, such as water ingress into electronics compartment, rusting, lubrication, and vibrations would be eliminated.