The Federal Cartel Office said it would look closely at Amazon's business practices after receiving "many complaints" from retailers and manufacturers selling goods through its German website amazon.de.
"Amazon functions as a kind of 'gatekeeper' for customers", Andreas Mundt, head of Germany's Federal Cartel Office, said in a statement.
"Its double role as the largest retailer and largest marketplace has the potential to hinder other sellers on its platform."
The probe is the latest setback for Amazon after the European Commission in September opened a preliminary investigation into suspicions the retailer uses the data it has about its third-party sellers to gain a competitive edge.
The Federal Cartel Office said its investigation would "supplement" the Brussels probe.
The German watchdog said it would examine Amazon's "terms of business and practices towards sellers", including taking a closer look at rules for product reviews, use of data and the "non-transparent" blocking or closing of sellers' accounts.
In a statement to AFP, Amazon said it could not comment on ongoing proceedings.
"But we will fully cooperate with the Federal Cartel Office and continue to work on supporting the growth of small and middle-sized companies," a spokesman said.
The company pointed out German SMEs had sold € 2.1 billion in goods around the world through Amazon last year.
German Justice Minister Katarina Barley of the centre-left Social Democrats (SPD) welcomed the investigation into the online retail behemoth.
"The large internet platforms not only shape our everyday lives, they have also gained significant market power," Barley told business daily Handelsblatt.
"They must not abuse this dominant position against small traders… And if necessary, the appropriate measures must be taken."
The opposition Greens party called for tougher European oversight of global corporations to ensure free and fair conditions for smaller players.
"Amazon has become the central infrastructure of the internet," its lawmaker Katharina Dröge told national news agency DPA.
"For many retailers, Amazon is as important today as roads and a telephone," she said.
The probe comes as US tech giants, also including Facebook, Google and Apple, are increasingly under scrutiny in Europe amid heightened concerns about data privacy, market dominance and avoidance of corporate tax.
French President Emmanuel Macron has led calls for a minimum tax rate for companies such as Apple, Google and Amazon to be applied on their revenues throughout the European Union.