Dustum was introduced to the cabinet and took up his new post as chief of staff of the high command of the country's armed forces, Karzai spokesman Khaliq Ahmad said.
The former general's new position is believed to be largely symbolic, but it is crucial for Karzai as it removes the ethnic Uzbek leader from his powerbase in the northern town of Shiberghan.
On Sunday, Dustum resigned as leader of his Jinbish Mili Islami Party.The faction has now been registered as a political party, allowing it to run in the country's first parliamentary elections due later this year.
Afghanistan's 2002 constitution bars military men from leading political parties.
US-backed President Karzai has been trying to bring local military leaders under control by offering them government posts in the capital Kabul.
Afghan President Hamid Karzai
(R) is backed by the US
Most of the leaders, who helped US-led forces topple the Taliban in late 2001, have been accused of involvement in drug-trafficking and factional fighting in the past, which has cost scores of lives.
Known for a taste for whisky and a love of cultivating roses, Dustum - a nickname meaning everybody's friend - gained a reputation as a particularly brutal but unreliable ally during the years of violence that have shattered Afghanistan.
However, Dustum, currently living in Kabul, has begun to disarm his militia as part of a United Nations-backed scheme. He was allowed to retain a personal retinue of 200 bodyguards.
Dustum survived an assassination attempt on 20 January, and was an unsuccessful candidate in last October's presidential election. He won 10% of the vote, largely among the Uzbek and Turkmen minorities.
In a separate development, two children have died following an explosion in Itesarq Mena, west of Gardez city on Sunday.
"At about 6pm (1330 GMT) a bomb, which was moved by water to a residential area, exploded killing two children, and injuring two other infants," local security chief Ghulam Nadi Salim said.
One of the injured children was in a critical condition. The children were playing with the device, carried by floodwaters into a residential area, when it exploded.
US soldiers evacuated one child to a nearby base for treatment, he added.
It was unclear whether the ordnance was recently planted by insurgents or was a leftover from the two and a half decades of conflict in the country.
Afghanistan has been hit by floods, caused by snow melting in the wake of a harsh winter, which have dislodged a number of old mines and other unexploded ordnance resulted in new injuries.