"Why am I staying? I'm staying in the post of defense minister because I know what kind of challenges face Israel - Gaza, Hezbollah, Syria, Iran, the rehabilitation of the military and the political process," Barak said.
If Barak had pulled his Labor Party's 19-member faction out of the coalition, Olmert would have been stripped of his parliamentary majority.
Such an outcome would likely have brought forward elections, which are currently scheduled for November 2010.
|Israel was accused of indiscriminately bombing|
Lebanese towns and cities during the war [AFP]
Barak hopes to reclaim the prime minister's post, which he lost in 2001 elections, but the Labor party trails to Benjamin Netanyahu's conservative Likud party in opinion polls.
A Netanyahu victory would not bode well for the aim of George Bush, US president, to broker a peace accord between Israel and the Palestinians before he leaves office next January.
The two sides agreed in November to restart peace talks after a seven-year break.
Barak's decision to remain in government is a boost to Olmert, whose fragile political standing was regarded as being harmful to the peace drive.
Given the opinion poll results, Barak's decision to remain in government had been expected.
"I know that I could pay a political price for this decision," he declared in announcing his plans before Israel's weekly cabinet meeting.
'Chance to rebuild'
Olmert issued his first public pronouncement on the Lebanon war report at the start of the meeting, without addressing Barak's decision to remain in his government.
"This report is not a source of happiness," Olmert said.
"It's the source of the possibility for an opportunity to correct things that were uncovered, to improve them and rebuild, if necessary, and lead Israel forward."
The war erupted on July 12, 2006, when Hezbollah fighters crossed into Israel, killing three Israeli soldiers and capturing two others.
Israel retaliated with a series of air raids and ground offensives against Hezbollah in Lebanon, but was internationally criticised for indiscriminate targeting of civilian areas.
Olmert's popularity with the Israeli public nosedived after the military campaign failed to crush Hezbollah and secure the release of the captured soldiers.
Israeli reservists returning from the battlefield said they had little training and were poorly equipped to lead their missions.
Between 1,035 and 1,191 Lebanese civilians and combatants were killed during the war, as were 119 Israeli soldiers and 40 civilians, according to official figures from both sides.