The internal inquiry into the March 31 raid, which falls short of a UN proposal for an international investigation, was decided on after consultations with the United States.
The White House welcomed the move as an important step and said Israel was capable of conducting a fair investigation.
"But we will not prejudge the process or its outcome, and will await the conduct and findings of the investigation before drawing further conclusions," White House spokesman Robert Gibbs said in a statement.
Israeli Prime Minister Benjamin Netanyahu's office said in a statement the government would give its final approval on Monday to forming an "independent public commission" into whether or not Israel had conformed to international law in imposing a naval blockade on the Hamas-ruled Gaza Strip.
Israel said its commandos killed nine pro-Palestinian Turkish activists when they boarded a Turkish-flagged aid vessel and were attacked by passengers wielding metal rods and knives.
The committee will examine the flotilla members, as well.
Amid an international outcry over the bloodshed, Israel has faced mounting pressure to investigate the events surrounding the flotilla raid and to ease or lift its blockade.
Hamas, who refuse to recognise Israel and renounce violence, seized control of the Gaza Strip in 2007.
Foreign participation
Netanyahu said on Sunday Israel would continue discussions with the international community to prevent weapons and military equipment from reaching Gaza and to allow in humanitarian aid, an apparent signal it was open to revising blockade procedures.
The statement said a retired Israeli Supreme Court judge, Jacob Turkel, would head a committee on which two other Israelis and the two foreign observers would sit.
"In light of the exceptional circumstances of the incident, it was decided to appoint two foreign experts who will serve as observers," the statement said.
The statement listed David Trimble, a Northern Ireland politician and Nobel Peace Prize winner, and Canadian jurist Ken Watkin as the foreigners who would take part in the hearings and deliberations but not have the right to vote.
"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 statement said.
The Israeli military has announced its own investigation, focusing on the operational aspects of a raid seen by many in Israel as a fiasco in which planners failed to gauge the strength of resistance on board.
Officers and soldiers would not testify at the government-ordered inquiry, which would rely on the statements they made to the military panel, Netanyahu's office said.
The commission will publish its report when finished.
"While Israel should be afforded the time to complete its process, we expect Israel's commission and military investigation will be carried out promptly," the White House statement said.
"We also expect that, upon completion, its findings will be presented publicly and will be presented to the international community."
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