Zinc oxide (ZnO) crystals with additions of iron (III) oxide exhibit a characteristic inversion domain microstructure with domain boundaries on two different habit planes: parallel to {0001} basal planes and parallel to {2 $(1) over bar $$(1) over bar $5} pyramidal planes of ZnO. The structural inversion of the domains is proved by electron diffraction experiments. In the present transmission electron microscopy study, emphasis is placed on the early stages of domain formation in sintered polycrystalline material and in diffusion couples with single crystals of ZnO. For solute iron content >0.5 at.% of the cations, defects nucleate at the surface and in the interior of ZnO grains at >900 degrees C. These primary defects propagate along the basal planes of ZnO and gradually widen in the positive c-axis direction of the ZnO host crystal. The widening along c is promoted by a second defect on {2 $(1) over bar $$(1) over bar $l} planes that moves away from the basal plane defect. The c-axis orientation in the ZnO region swept by the second defect is inverted, finally resulting in the inversion domain microstructure. A low iron content approximate to 0.1 at.% was measured in the inverted domains. Energy-filtered imaging and quantitative electron energy-loss spectroscopy show that the inversion domain boundaries (IDBs) parallel to the basal planes contain a full close-packed monolayer of iron whereas the pyramidal IDBs are occupied by iron with approximate to 2/3 of the content of the basal IDB. Based on experimental observations and arguments of structural chemistry, a mechanism is proposed explaining the nucleation and oriented growth of the inversion domains that are finally induced and driven by the trivalent iron ions at octahedral sites in the primary defects.