"The prime minister has decided to appoint Virender Dayal, former under-secretary to the United Nations, as a special envoy of the government of India to liase with UN and members states ...to gather relevant material regarding the involvement of Indian entities," the prime minister's spokesman Sanjaya Baru told reporters.
He said initially Dayal's tenure would be for three months.
"The government of India is also contemplating other steps which will also be announced shortly," Baru added.
Several television channels said there would be pressure on the foreign minister to resign if such a probe was ordered.
A UN report by former US Federal Reserve chairman Paul Volcker said Singh and the Congress party were among beneficiaries world-wide allowed to buy Iraqi oil at below market rates in return for kickbacks to the regime of Saddam Hussein.
Natwar Singh met Prime Minister Manmohan Singh and Congress party leader Sonia Gandhi earlier in the day to discuss the Volcker report.
"We discussed the Volcker report. We also discussed other pressing foreign policy matters," Natwar Singh told reporters after the meeting.
The Times of India newspaper said that after going through the Volcker report, Fiunance Minister Palaniappan Chidambaram and Science and Technology Minister Kapil Sibal advised the prime minister that Natwar Singh could not be cleared immediately.
But the two ministers felt confident that it would be possible to get the Congress party cleared, the newspaper said.
Last week the foreign minister rejected opposition demands to resign, saying he enjoyed the full confidence of Congress party chief Gandhi and of the prime minister.
The Volcker report named him as a non-contractual beneficiary of four million barrels of Iraqi oil allotted to a firm named Masefield AG.
The report said it found that Saddam's regime manipulated the programme to extract about 1.8 billion dollars in surcharges and bribes, while an inept UN headquarters failed to exert administrative control.
The ruling Congress party, India's oldest political entity, is also listed as a beneficiary of a separate allotment of four million barrels of oil as part of the transactions.