Julia Gillard, Australia's acting prime minister, said the aim of the inquiry would be to bring a better understanding of what happened for the families of those who died.
"More than 600 of our nation's finest sailors and airmen lost their lives and we still don't know exactly how [the ship] met her end," said Gillard, who is standing in for Kevin Rudd, the Labor prime minister, while he is abroad.
"I know that this inquiry will have special significance to the families of those who lost loved ones."
"This inquiry will have special significance to the families of those who lost loved ones"
Australian acting PM
The loss of the pride of the Australian fleet shocked Australia and sparked numerous searches to find the wreckage.
The Sydney was the biggest ship to be lost with no survivors from either of the two world wars.
Angus Houston, Australia's defence force commander, said he wanted the inquiry to find out what happened to the Sydney and why there were no survivors.
On the Kormoran, only 80 were killed and more than 300 sailors survived.
"No board of inquiry was conducted during World War Two so this is very much unfinished business," Houston told reporters.
|Sonar imagery found the Kormoran wreck and|
the Sydney nearby [Reuters/Australian DoD]
Terrence Cole, a retired judge, will head the inquiry, and is expected to call for survivors of the Kormoran – the only living witnesses to the sea battle - to give evidence on what happened.
Cole will also review information collected by the team that found the Sydney and the Kormoran.
They have returned to the area with robotic submersible to collect video and photos of the hulks.
The Sydney was last sighted sailing ablaze over the horizon after the encounter with the Kormoran, which was disguised as a Dutch freighter.
Underwater footage of the two wrecks and a nearby debris field may provide clues as to how the Sydney, a superior warship, allowed itself to be drawn within range of the raider's guns and torpedoes.
After the battle, the 317 survivors of the Kormoran's 397-member crew rowed lifeboats to the Australian coast and were taken prisoner.
A government-funded research ship found the Sydney last month at a depth of 2,470 metres, about 240km off the coast of Western Australia.
The wreck of the Kormoran was found 22 km away.