The joint venture will combine Mengniu's market-leading position with Danone's technology and marketing know-how to offer Chinese consumers high quality dairy products, said Danone in a statement.
Danone already has a stake in Shanghai-based Bright Dairy, which produces and markets Danone brand yoghurts in China.
But Bright Dairy has seen sales and profits decline in recent years, partly due to a scandal linked to the reprocessing of some of its products in the south.
Inner Mongolia-based Mengniu and another dairy in that region, Yili, have risen to the top of the sector during this time, and with growing competition in the Chinese dairy industry, foreign players like Danone are increasingly seeking a larger piece of the action by getting more involved in production.
Danone's news follows last week's announcement by Fonterra that it would set up a dairy farm with its joint venture partner SanLu in China.
Both foreign players have underlined their know-how in producing quality products, and as incomes rise, Chinese consumers are spending more on what they perceive to be higher quality.
Mengniu has recently launched a premium milk brand, Telunsu, backed by a major advertising campaign as it seeks to create a differentiated, higher margin product.
Mengniu said today that it will invest CNY1.6 billion (€155m) in the production and sale of fresh dairy products under the joint venture, with CNY381.5 million worth of production facilities and properties.
Danone is already the leading producer of bottled water and biscuits in China and posted sales of around €1.2 billion there last year.
Under the new agreement with Mengniu, in which it holds a 49 per cent share, it will be aiming to increase its share of the dairy market, which still has considerable room for growth.
Per capita consumption is still very low, at an average 20kg, but this is expected to increase to 30kg in 2015.