The partnership opens up the prospect of more European ventures for Israel's high-tech defense industry, which racked up sales of $9.6 billion in 2010, as well as global export prospects.
The Jerusalem Post reported the deal was expected to earn IAI, state-owned flagship of Israel defense industry, "several hundred million dollars over the next five years."
Israeli business daily Globes said potential sales of the versatile twin-turboprop aircraft could total "billions of dollars over the next decade."
IAI already produces electronic intelligence aircraft, but this venture will be Airbus' first into the AEW&C sector.
IAI manufactures the Phalcon EL/M-2075, a larger AEW&C platform built around Boeing 707, Boeing 747, Boeing 767, Ilyushin Il-76, General Dynamics Gulfstream G550 business jet or Airbus airframes.
It carries Elta's AESA radar system that can track 100 targets up to a range of 200 nautical miles.
In March 2004, three built around Il-76 A-50 heavy lift airframes were sold to India for $1.1 billion.
An earlier deal in 2000 to sell four Phalcons to China for $1 billion was torpedoed by the United States, claiming the system included U.S. components.
The Israeli air force currently operates four twin-jet Gulfstream G550 conformal electronic intelligence aircraft known as Eitam, with another on order, along with 3 B-707 Phalcons.
IAA and Airbus Military signed a memorandum of understanding on the C295 Tuesday at the Paris Air Show at Le Bourget airport, where a prototype of the planned Airborne Early Warning and Control aircraft, built at Airbus Military's factory in Seville, was on display.
IAI and Airbus said the new plane's systems would include a fourth-generation active electronically scanned array radar with integrated Identification Friend and Foe system made by Elta Systems of Ashdod, an IAI subsidiary and Israel's leading radar manufacturer.
The Elint C295 is designed to provide high quality 360-degree surveillance and to create real-time integrated air and maritime intelligence that is shared with allied forces via network-centric data links.
A C295 fitted with a rotating radar dome mounted on the rear fuselage has been undergoing flight tests at an Airbus facility in Spain since June 8.
IAI's chief executive, Itzhak Nissim, called the plane a "strategic force multiplier."
Elta President Nissim Hadas told Globes the deal with Airbus Military constitutes a strategic agreement.
"Global demand for AEW planes like this is expected to grow in the coming years, due to terrorism threats and the need to tighten border controls, as well as for airborne control, he commented.
"Many countries around the world sense the need for such systems, and we're offering a relevant package for this market.
"I have no doubt that this agreement with a subsidiary of a giant like Airbus will enable us to break into new markets worldwide."
Most of Israel's defense industry sales in 2010 were accounted for by the four biggest companies in the sector, IAI, electronics maker Elbit Systems, Rafael Advanced Defense Systems and Israel Military Industries.
Of the overall $9.6 billion in sales, exports totaled $7.3 billion, Defense Ministry figures indicate.
IAI had the biggest orders backlog, amounting to $8.9 billion in 2010. Elbit's total was $5.4 billion.
There have been plans to privatize IAI, which currently has a workforce of 17,500 producing missiles, unmanned aerial vehicles and other weapons platforms.
The privatization process is expected to accelerate when IAI's current chairman, Yair Shamir, ends his six-year term in July.
Defense Minister Ehud Barak and Finance Minister Yuval Steinitz announced June 5 Shamir will be replaced by Dov Baharav, former president and CEO of Amdocs Ltd., one of Israel's largest companies that specializes in software, billing and management and other services.