The deal remains subject to a PSA shareholder vote and is likely to be signed formally during Chinese President Xi Jinping's visit to Paris in late March, sources say.
Under the memorandum of understanding signed today, Dongfeng and the French state will each pay about 800 million euros ($1.1 billion) for a 14-percent stake in a reserved share sale and a rights issue, sources have said.
The capital tie-up will end the Peugeot family's control of the 200-year-old French company. The Peugeot family's 25 percent stake and its 38 percent of voting rights would be diluted to parity with the government and Dongfeng, leaving it short of the one-third required to veto decisions.
The deal will help PSA survive the withdrawal next year of 7 billion euros in state guarantees to its sales financing arm. The guarantees are keeping the French firm afloat.
PSA is among the worst casualties of Europe's six-year market slump and is being kept alive by state guarantees that expire next year.
The company has been slow to adapt to competition and critics argue it has missed opportunities for strategic partnerships in the past, such as with BMW or Japan's Mitsubishi Motors.
Even so, the tie-up with Dongfeng has divided the Peugeot family and some analysts have cast doubts over the logic behind the deal, saying PSA could instead sell its lending arm or its Faurecia parts division.
Questions also have been raised over what Dongfeng would gain through the tie-up beyond putting some of its excess cash to work. As of the end of June, Dongfeng had 24 billion yuan ($3.96 billion) worth of cash or cash equivalents, according to its mid-year report.
A Dongfeng source said the interim agreement would include cooperation on technology but industry experts doubt PSA will be willing to share engineering know-how that would upgrade the Chinese firm's Fengshen line of vehicles.