"In light of the exceptional circumstances of the incident, it was decided to appoint two foreign experts who will serve as observers," the statement from Netanyahu's office said.
"The commission may request any information from the Prime Minister, the Minister of Defence, other ministers and the Israel Defence Forces Chief-of-Staff."
The format of the inquiry was decided on after consultations with Washington but falls short of UN calls for an international investigation into the raid which left nine people dead.
"The demand for a UN investigation shows a clear double standard towards Israel," an official in Netanyahu's office said.
Israeli commandos attacked the flotilla on May 31 and killing nine activists on the largest vessel, the Turkish-flagged Mavi Marmara.
Israel has faced international condemnation since the attack, especially from Turkey which had been an ally prior to the raid.
Abdullah Gul, the Turkish president, has said that Israel's raid has caused "irreparable" damage to his country's relations with Israel, and will "never" be forgiven.
Israel has defended its use of force and said its commandos were attacked by passengers on the flotilla wielding metal rods and knives.
The Israeli military has announced its own investigation, focusing on the operational aspects of the raid, and officers and soldiers will not give testimony directly to the
Instead the government appointed commission will rely on statements made to the military panel, Netanyahu's office said.
Some Israeli diplomats in Jerusalem have reportedly expressed doubts about whether a commission where Israel investigates itself will satisfy the international community.
Unconfirmed reports in the Israeli press suggest that 'investigators' will not be able to interview naval commandos who took part in the raid or the head of the Israeli navy who issued the orders.
In a statement on Sunday the White House welcomed the move as an important step and said Israel was capable of conducting a fair investigation into the circumstances surrounding the raid.
"But we will not prejudge the process or its outcome, and will await the conduct and findings of the investigation before drawing further conclusions," Robert Gibbs, a White House spokesman, told reporters.
Susan Rice, the US ambassador to the United Nations said the "international component" would enhance the credibility of an Israeli inquiry.
The original goal of the flotilla campaign was to pressure Israel to cease its blockade of the Gaza strip.
Netanyahu has confirmed that discussions about ending the blockade have taken place between the US, Israel, and Tony Blair, the envoy of the Quartet of Middle East Peacemakers which includes Russia and the European Union.