Thursday's inquiry was announced by military chief of staff General Peter Cosgrove and top defence department official Ric Smith.
Smith told parliament earlier this week that Canberra received reports on the prisoner abuse months earlier than the government previously acknowledged.
A departmental officer has been appointed to lead the inquiry into what the Australian Defence Force knew about issues concerning the treatment of Iraqi detainees and when, according to a joint statement.
The team will report its conclusions before parliament resumes on 15 June.
Cosgrove and Smith were forced to apologise to a Senate committee on Tuesday after defence officials claimed Australia only learned in January about allegations that inmates in Baghdad's notorious Abu Ghraib prison were being abused by their US captors.
Prime Minister John Howard went before parliament on Monday to deny media reports that Australian military and defence officials were aware of the abuse allegations as early as October.
Howard insisted he only learned of the scandal when it became public in April and other senior ministers said they only learned of the matter in January.
But Cosgrove, Smith and other officials from the foreign ministry admitted that members of their departments were aware of the abuse reports last year.
Australia is a central figure in the US-led "war on terror", a position that led to 88 of its citizens being killed in the bombing of a Bali nightclub in 2002.
Canberra is one of Washington's
staunchest supporters in Iraq
Since then it has rounded up dozens of "terror suspects" using new laws that have been criticised for being blunt and oppressive.
Suspects will face tougher bail conditions and those convicted may spend longer time in jail after the government moved to tighten laws on Thursday following a right-wing backlash over recent bail decisions.
Sydney man Bilal Khazaal, 34, was charged by police on Wednesday with trying to facilitate "terrorist acts" by publishing a book of rules for jihad.
The offence carries a maximum penalty of 15 years in jail.
Khazaal was granted bail and his case adjourned until next month, a ruling which provoked heavy criticism.
"Notwithstanding the seriousness of the offence, we would say the decision to grant bail is inadequate on this occasion," said New South Wales state police commissioner Ken Moroney.