Unless users delete their Instagram accounts by a deadline of 16 January, they cannot opt out.
The changes also mean Instagram can share information about its users with Facebook, its parent company, as well as other affiliates and advertisers.
The move riled social media users, with some likening it to a "suicide note".
The new policies follow Facebook's record $1bn (£616m; 758 euro) acquisition of Instagram in April.
Facebook's vice-president of global marketing solutions Carolyn Everson earlier this month had said: "Eventually we'll figure out a way to monetise Instagram."
This means that even people who do not use Instagram could find themselves in an advertisement, if a friend snaps a picture of them and shares it.
But Instagram said that its aim was to make it easier to work with Facebook.
"This means we can do things like fight spam more effectively, detect system and reliability problems more quickly, and build better features for everyone by understanding how Instagram is used," it said in a statement.
However, the updated policy will not change how it handles photo ownership or who is able to see a user's pictures, it added.
But the new policy has triggered a backlash among social media users, with some threatening to quit.
One user tweeted: "Good bye #instagram. Your new terms of service are totally stupid and nonsense. Good luck playing with the big boys."
New York-based photographer Clayton Cubbit wrote on his account that the new policy was "Instagram's suicide note".
Analysts said that the new policies could deal a blow to Facebook's reputation and alienate some users.
Alan Pelz-Sharpe, research director at 451 Research, added: "It's a barefaced tactic that Facebook and Instagram have taken, and one that will likely meet with many challenges, legally and ethically.
"The fact is that Facebook has critical mass, and is quite confident that such moves may cause uproar, but not a flight of business.
"Larger firms like Facebook are essentially trailblazing before specific regulations can catch up with them, and as we have seen with Google in the past, regulations and laws have limited real impact on their business operations - so they tend to move forward regardless of opposition."