Victims of the deadly rampage and human rights workers criticised the decision, saying the United Nations should continue to push for an international tribunal, similar to the ones for Rwanda and former Yugoslavia.
The Catholic Church joined in, saying, "The victims and their families ... deserve nothing less."
Nearly 1500 people died when Indonesian military and their proxy militias went on a killing, looting and burning spree in 1999, after East Timorese voted overwhelmingly to end nearly 25 years of Indonesian occupation.
The bloodletting continued until Australian-led international peacekeepers stepped in.
Jakarta has resisted pressure for a full-blown international tribunal, and Dili has gone along with it - saying it did not want to jeopardise bilateral relations.
The two countries said on Monday that the 10-member "Truth and Friendship Commission" was an opportunity "to heal past wounds".
Rights workers insist the UN should
push for an international tribunal
For the next year, the five Indonesian and five East Timorese panel members will interview people and review documents as they try to establish the truth about the violence, said Indonesian Foreign Ministry spokesman Yuri Thamrin.
The commission members - including a retired general, legal experts, a priest and a judge, among others - will meet for the first time on Thursday on the resort island of Bali, largely to discuss their agenda, he said.
East Timor, which is contributing one-third of the commission's $1.5 million budget, brushed off criticism that the body was largely toothless.
"We do not believe the establishment of an international tribunal is the only way to find truth or justice," Foreign Minister Jose Ramos Horta said in Dili.
"We do not believe the establishment of an international tribunal is the only way to find truth or justice"
Jose Ramos Horta,
East Timor foreign minister
But for some, the commission reflects the limits of East Timor's hard-won independence.
Political, social and economic ties run deep, and the tiny country sees no benefit in jeopardising relations with its giant neighbour.
East Timor, the poorest nation in Asia, gets more than 80% of its imports from Indonesia and is dependent on its former occupier for electricity and gas. All flights pass through Bali island, and many of Indonesia's laws are still on the books.