The German powerhouse has been striving to make inroads in India and other emerging economies as markets in developed countries become saturated.
"India is a strategic market for us," Volkswagen
India president Mahesh Kodumudi said in New Delhi, adding that over the next five to six years the company would invest 15 billion rupees (€185 million) in the country.
Volkswagen, which holds just over two percent of the Indian car market, will pour funds into localizing production in a bid to cut costs and better compete with rivals.
The announcement came as Volkswagen, which entered India in 2001 with the Skoda brand, said in a statement it was launching a newer version of its premium Polo hatchback, priced starting at 499,000 rupees (€6,100).
Volkswagen makes the Polo at its plant in Pune in western India, giving it a niche in the country's crucial small car segment, which accounts for some 70 percent of total domestic sales.
The company also is pushing other increasingly popular lines in India, such as sports utility vehicles and compact sedans.
Volkswagen wants to be the world's top carmaker by 2018, surpassing Toyota and General Motors.
Carmakers have been grappling with a fall in Indian car sales triggered by a sharp slowdown in domestic economic growth and high interest rates.
But analysts say India holds huge promise longer term as the country of 1.25 billion people has one of the world's least-penetrated car markets.
A new right-wing government came to power in India in May, promising a return to higher economic growth. Volkswagen's announcement was one of the first big foreign investment decisions since the election.
Analysts say a young population, rising incomes and a resurgence in economic expansion will accelerate growth in the Indian car market.
Last month, in what analysts said could be a portent of better times ahead, new Indian car sales made their biggest gains in 10 months, rising 15 percent from a year earlier to 160,232 units, the Society of Indian Automobile Manufacturers said.
Volkswagen said it may make engines in India, adding the western state of Maharashtra would be its first preference for setting up an engine plant, according to the Press Trust of India (PTI) news agency.