The agreement, which seals talks that began last November, will allow Toyota, Japan's top automaker, to take advantage of Isuzu's highly reputed diesel technology.
Production of the 1.6 liter diesel engines for use in Toyota vehicles sold in Europe will start 2012, the companies said in a statement.
Demand for diesel vehicles is growing especially in Europe because of worries about global warming. Diesel is widely known for good mileage, and recent innovations have made diesel cleaner.
Toyota already produces diesel engines in Europe, but it has tended to focus more on so-called hybrid technology, in which a car switches between a gas engine and an electric motor for fuel efficiency.
The agreement allows Toyota to get help from Isuzu to compete in diesel technology with rivals such as Honda Motor Co., which is strengthening its diesel lineup.
Toyota and Isuzu said the companies were working out details on development, production and supply of the diesel engine, but Isuzu "will play the leading role."
Toyota owns a 5.9 percent stake in Isuzu. Isuzu formed a capital alliance with Toyota in November after dissolving its tie-up with General Motors Corp. in April 2006.
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