A laser heterodyne interferometer with rotational error compensation is proposed for precision displacement measurement. In this interferometer, the rotational error of the measured object is obtained by using an angle detecting unit which is composed of a semi-reflective film, a polarizing beam splitter, a quarter-wave plate, a convex lens and a two-dimensional position sensitive detector. And the obtained rotational angle is used for compensating its influence on displacement measurement result. The optical configuration of the proposed interferometer is designed, and the mathematical model for displacement measurement with rotational error compensation is established. The coupling effect of axial displacement on rotational angle measurement and the rotational angle range used for compensation on displacement measurement are discussed in detail. To verify feasibility of the proposed interferometer, the experimental setup was constructed and several verification experiments were performed.