The decision was taken at a cabinet meeting here presided over by Prime Minister Manmohan Singh.
The inquiry will look into the "physical/electronic surveillance" in Gujarat, Himachal Pradesh and Delhi "allegedly without authorisation", an official statement said.
According to sources, a retired Supreme Court judge may be named to head the commission of inquiry. The announcement is likely to be made in a few days.
Two news portals claimed last month that Shah ordered the illegal surveillance of a woman at the behest of a "saheb", widely believed to be Gujarat Chief Minister Narendra Modi.
The Gujarat government has already ordered a probe into the case. Shah is now Uttar Pradesh in-charge for the Bharatiya Janata Party.
The Congress had earlier alleged that the woman was close to Modi and was put under surveillance by the then minister of state for home and Modi-aide Amit Shah in 2009, after Modi suspected the woman of being close to an IAS officer.
A group of women activists, including Mahila Congress members, had even approached the president demanding a judicial probe into the incident.
Congress leader Digvijaya Singh said: "Congratulations to central government, this should have happened earlier."
The BJP reacted angrily to the decision, saying the real target was Modi, now the party's prime ministerial candidate.
"The centre's decision to institute a fresh commission of inquiry into the alleged snooping case is an attempt to tarnish the image of Gujarat government," BJP president Rajnath Singh said.
"The Congress is trying to hit at the principal opposition party's prime ministerial candidate. It is a clear case of political vindictiveness coming into play," BJP spokesperson Nirmala Sitharaman said.
Leader of Opposition in the Rajya Sabha Arun Jaitley termed the cabinet move as "politically motivated" and said it was against the "federal structure".
"It is a step against the federal structure of our constitution. When the state government had already ordered a probe into the case then what was the point behind setting up a new commission of inquiry," he said in a statement.
"The setting up of a parallel commission by the central government ostensibly on the pretext of this issue covering more than one state is without any basis... I am sure it will be legally challenged in courts," Jaitley said.
--IANS (Posted on 26-12-2013)