The group said the army had performed a U-turn after initially refusing to look into the killing of Bassem Abu Rahmeh, 30, who was struck in the chest by a tear-gas canister on April 17, 2009 at a protest in the village of Bilin.
The decision to investigate follows a B'Tselem probe into the incident, spokeswoman Sarit Michaeli said.
The military would not immediately confirm if it had opened an investigation.
"This is such a clear-cut case, it was so blatant, that the refusal to investigate was just wrong," Michaeli said, adding that the incident was captured by three separate video cameras.
She added, however, that it was "extremely rare" for Israeli soldiers to be held accountable for killing Palestinian civilians. "The track record is not good," she said.
B'Tselem said the decision was announced in a letter to Abu Rahmeh's lawyer Michael Sfard, who had threatened to petition the supreme court after an international forensics team found that troops had fired the canister at him in violation of firing regulations.
The high-velocity projectiles are designed to disperse crowds but can be lethal if fired directly at individuals.
The canister which struck Abu Rahmeh was similar to one that hit US activist Tristan Anderson in the head in March 2009 at a protest in the nearby village of Nilin, causing serious brain damage.
Residents of the two West Bank villages, along with foreign and Israeli supporters, hold weekly protests against the construction of Israel's controversial separation barrier.
The demonstrations are billed as non-violent but clashes frequently erupt, with Palestinian youths slinging stones and Israeli troops firing tear-gas, stun grenades and rubber bullets.
In a video of the incident released by B'Tselem, Abu Rahmeh can be seen shouting at the soldiers from the village side of the fence for several minutes before the tear-gas canister hits him in the chest.
He then stumbles a few (metres) yards before falling to the ground, as a bloodstain expands across the front of his bright yellow shirt. The three graphic videos can be viewed at www.situstudio.com/bil-in/.
At the time of the incident, the military concluded that the canister had accidentally ricocheted off a wire, B'Tselem said. Its conclusion, which was based on statements by soldiers, was rejected by the forensics team.