Avigdor Lieberman and his Yisrael Beitenu party will add five lawmakers to Netanyahu's previously wafer-thin majority if the coalition deal is given parliamentary approval as expected.
Lieberman, who has spoken of harsh measures against Palestinian "terrorists", will take over the key role of defence minister after being sworn in.
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Netanyahu said that "we are joining hands now to march Israel forward."
The move to hand the defence ministry to the 57-year-old hardliner has sparked deep concern among Israeli centrist and left-wing politicians, as well as among some of Netanyahu's Likud party colleagues.
Religious nationalists from the Jewish Home party already hold key cabinet positions in Netanyahu's government.
Moshe Yaalon, a Likud member who resigned as defence minister on Friday and who has also served as armed forces chief, warned of a rising tide of extremism in the party and the country as a whole.
Former Labour prime minister and defence minister Ehud Barak went further, saying Israel's government "has been infected by the shoots of fascism."
The Palestinian leadership condemned Lieberman's move into the government.
"The existence of this government brings a real threat of instability and extremism in the region," Palestinian chief negotiator Saeb Erekat told AFP, adding that the appointment would "result in apartheid, racism and religious and political extremism."
Others say that Lieberman is above all a pragmatic politician who aspires to be prime minister one day, noting that he will face opposition from the security establishment if he seeks to carry out some of his most controversial ideas.
An example of his provocative style was recently on display in comments directed at Ismail Haniya, Islamist movement Hamas's leader in the Gaza Strip.
Lieberman said he would give Haniya 48 hours to hand over two detained Israeli civilians and the bodies of soldiers killed in a 2014 war "or you're dead".
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