The island's 1,300 residents and businesses will benefit from incentives financed by the Greek government to get rid of petrol and diesel cars, and VW will offer electric vehicles at low prices, a government source said.
Volkswagen said the project aimed to reinvent the island's transport system, with local bus service replaced by an all-electric year-round ridesharing service.
Many vehicles on the island are rentals to ferry the 72,000 tourists that visit each year, and the project aims to have visitors use the ridesharing system, which will include electric scooters and bikes as well as cars.
Deputy Foreign Minister Kostas Fragogiannis said the initiative was an example of how governments and corporations could work together to "promote climate protection, (and) apply innovative solutions to improve people's lives."
Volkswagen plans to install chargers across the island of 100 square kilometres.
VW chief executive Herbert Diess said the network of electric vehicles "will improve the quality of life, while contributing to a carbon neutral future."
An OECD report published last month found that Greece had made considerable progress in reducing greenhouse gas emissions, but was being held back by the heavy reliance of islands on fossil fuels for transportation and heat.
