The announcement by Israeli President Shimon Peres means Mr Netanyahu now has six weeks to put together a ruling coalition.
His centrist rival Kadima leader Tzipi Livni said they would not join him but operate as an opposition party instead.
Mr Peres made his announcement after meetings with Mr Netanyahu and Ms Livni as he decided which candidate would be given the task of cobbling together a new coalition in the aftermath of Israel's national election last week.
The choice of Mr Netanyahu was cemented yesterday when Avigdor Lieberman, who heads the hawkish Yisrael Beiteinu (Israel Our Home) party, endorsed the Likud leader.
Kadima edged out Likud in the election, capturing 28 seats to Likud's 27. But Likud is in a better position to put together a coalition because of gains by Mr Lieberman and other hard-line parties.
Mr Netanyahu now can form a hard-line government or try to bring Ms Livni into a broad coalition that would provide more stability and help Israel avoid a clash with the Obama administration and much of the world.
Emerging from her meeting with Mr Peres, Ms Livni said she would not join a hard-line government and was prepared to sit in the opposition "if necessary."
"I will not be able to serve as a cover for a lack of direction. I want to lead Israel in a way I believe in, to advance a peace process based on two states for two peoples," she said.
Mr Netanyahu might have little choice but to forge a coalition with nationalist and religious parties opposed to peacemaking with the Palestinians and Israel's other Arab neighbours.
This could set Israel on a collision course with the US, the Jewish state's top international patron, and its new president, who has vowed to make Middle East peace a priority. And Mr Netanyahu's hold on power would be more tenuous in a narrow coalition of rightists, where his allies could bring down the government in the face of any concession for peace.
Ms Livni's vow to join the opposition could simply be posturing ahead of coalition bargaining following the endorsement of Mr Netanyahu by Mr Lieberman, an immigrant from the former Soviet Union who based his campaign on requiring Israeli Arabs to swear allegiance to the Jewish state or lose their citizenship.
His party came in third place in the February 10 election, after Kadima and Likud. That essentially allowed him to determine who would be able to muster the backing of a majority in parliament.
Mr Lieberman's stance toward Arabs has exposed him to charges of racism and many see him as a far-right extremist. However, he is opposed to the Orthodox Jewish establishment's control over key aspects of public life in Israel, one of several positions that has enabled him to find common ground with moderates.
While announcing his support for Mr Netanyahu yesterday, Mr Lieberman said he preferred a national unity government that included Ms Livni over a narrow hard-line coalition.
"We need a wide government with the three big parties, Likud, Kadima and Yisrael Beiteinu," he said. "Netanyahu will lead the government but it will be a government of Netanyahu and Livni together."
As the political wrangling in Israel gained momentum, sporadic violence continued in Gaza in the absence of a long-term cease-fire between Israel and Hamas. Militants fired mortar shells at an Israeli patrol along the Gaza-Israel border today and the troops returned fire. There were no injuries reported.
Egypt has been trying to mediate a truce since Israel ended its Gaza offensive on January 18. Hamas wants Israel to open Gaza's blockaded border crossings, while Israel wants a halt to arms smuggling and the return of a soldier captured in 2006.
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