Production will start in 2005 and the cars will be built at a new site in Kolin in the Czech Republic.
Details of the joint venture were unveiled at a special presentation in Kolin attended by, among others, PSA Peugeot Citroen president Jean-Martin Folz, Toyota president Fujio Cho and Czech Prime Minister Milos Zeman.
Although the companies will develop the cars as part of a joint initiative, each will have their own vehicles that will compete in the marketplace.
The idea of the venture, said both presidents, was to share costs. Total investment is set to top €1.5 billion.
Folz said: 'In early 2000, Chairman Cho and I first noted that our conclusions about changes in automobiles markets were the same concerning the importance of developing an innovative, affordable vehicle to meet forecast growth in the European small car segment.
'The new vehicle had to be simple yet attractive, inexpensive yet equipped with the latest safety and environmental-protection features, small but roomy enough for four passengers, and suitable for urban driving but comfortable on the highway.'
Toyota president Cho said the success of the project 'is the key to Toyota's future success in the European market'.
'This is because the European market for entry-level compact cars is expected to expand in the future and competition among the various automakers will intensify even further.'
Cho added: 'It goes without saying that for Toyota to survive this competition, it must first produce an outstanding new model.'
Folz said the objective of the partnership 'is not to produce one car to be marketed by both partners but rather to manufacturer different Toyota, Peugeot and Citroen models built on a common platform to be developed together.'
The manufacturers will produce petrol and diesel models of the cars.