Sites in Alabama and Michigan were also considered by Europe's biggest automaker which plans to invest about $1 billion in the plant.
The announcement came on a day that the euro soared to a new high against the dollar and General Motors executives in Detroit announced planned layoffs. It also comes about 20 years after VW closed its last U.S. plant.
Volkswagen has said the surging euro pushed along plans for a production facility in the United States. The euro's rise has made goods exported from Germany more expensive in the United States.
David Cole, chairman of the Center for Automotive Research in Ann Arbor, Mich., said the strong euro dictated Volkswagen's timing. He said making a mid-priced vehicle in Europe "can't be viable."
"They had to come here," Cole said. "It's a very competitive market. If you are going to do anything with that market you have to be here."
Stefan Jacoby, president and CEO of Volkswagen Group of America, received several standing ovations as he told Gov. Phil Bredesen and hundreds of people at a news conference that VW picked Chattanooga for the plant.
Jacoby said the company's selection of Chattanooga is part of a strategy aimed at "connecting more with U.S. customers."
Volkswagen said the new sedan will be designed specifically for the North American consumer.
Volkswagen currently holds a 2 percent share of the U.S. market and the plan sets a goal of selling 800,000 in 10 years.
The company statement said the plant near the Georgia and Alabama borders would create 2,000 direct jobs and "add a significant number of jobs in related sectors."
Parent Volkswagen AG said the company approved up to $991.4 million to build the facility, aiming for a capacity of 150,000 cars a year. It plans to start production in 2011.
VW picked Tennessee 25 years after Nissan Motor Co. became the first foreign automaker in the South at Smyrna, a Nashville suburb.
The 1,350-acre site at Enterprise South Industrial Park near interstates 75 and 24 between Nashville and Atlanta has long been seeking an auto assembly plant.
Chattanooga previously lost out on the $1.3 billion Toyota Motor Corp. plant that is being built near Tupelo, Miss., and the $1.2 billion Kia Motors Corp. plant that went to West Point, Ga.
"I know this announcement has been a long time coming," Jacoby told the Chattanooga audience.
Volkswagen executives said the new plant in the U.S., in addition to factories in India and Russia, is part of the company's strategy to become the world's No. 2 automaker.
Also, the South offers ample highway and rail connections and hundreds of existing suppliers but its main attraction is a pool of workers who have shown at other European and Asian assembly plants that they can live without the United Auto Workers union.
Kristine Moroskey, a United Auto Workers spokeswoman, declined comment Tuesday about the VW plant.
Volkswagen spokeswoman Jill Bratina said in a statement that the company "has both union and nonunion plants and this decision is made by our employees. In both the union and nonunion facilities Volkswagen prides itself on a collaborative relationship with our employees."
Volkswagen earlier this year relocated its North American headquarters from suburban Detroit to northern Virginia.
Volkswagen's only other North American plant is in Puebla, Mexico. The company closed its last U.S. production facility near Pittsburgh in 1988.
Foreign auto assembly plants closest to Chattanooga are Honda in Lincoln, Ala.; the plant Kia Motors Corp. is building at West Point, Ga., and Nissan at Smyrna, all about 100 miles away. Tennessee is also corporate home to Nissan North America, which dedicates a new headquarters July 22 in the Nashville suburb of Franklin.
Shares of Volkswagen, whose brands include VW, Audi, Skoda, Bentley, Bugatti and Seat, were up 2 percent to $276.18 after the announcement.