Critics of Ehud Olmert, the Israeli prime minister, have said he launched an ill-prepared campaign in Lebanon that failed to defeat Hezbollah.
Hezbollah fired nearly 4,000 rockets into Israel during the 34-day conflict and Israeli reservists who fought in Lebanon have complained of poor planning and tactics.
Thousands of Israelis have taken part in protests to demand an independent inquiry into the war by a commission whose members would be appointed by a supreme court judge.
Olmert has said such an investigation, which in past Israeli-Arab wars has led to high-level resignations, would be too time consuming.
Instead, the cabinet approved by a vote of 20-2, with one abstention, Olmert's nomination of Eliayhu Winograd, a retired judge, and four others to a panel that will examine how political leaders and military commanders conducted the war.
Outside the prime minister's office, dozens of veterans held a demonstration, holding signs calling on Olmert, Amir Peretz, the defence minister and Dan Halutz, the military's chief of staff, to resign.
The protesters displayed a donkey and a sign reading: "Only an ass does not see that the Winograd Committee is a whitewash."
Peretz, leader of Olmert's main coalition partner, the Labour Party, voted in favour of the government-appointed panel, the defence ministry said.
Peretz had pushed for an independent probe of the war in which 157 Israelis, mostly soldiers, and nearly 1,200 people in Lebanon, most of them civilians, were killed before the fighting ended in a UN-brokered truce on August 14.
"I very much hope that the panel will complete its work in the near future, as soon as possible, and will assist the State of Israel in better preparing for the challenges that await us," Olmert said during the cabinet session.
As a retired judge, Winograd is empowered under Israeli law to ask the justice minister to grant the panel the same powers of subpoena and witness immunity that an independent, "state inquiry" would enjoy.
Other members of the inquiry board include two reserve generals, a jurist and a public policy professor.