He was born Wilhelm Dieterle in Ludwigshafen, Germany, the youngest child of nine to parents Jacob and Berthe Dieterle. As a child, he lived in considerable poverty and earned money by various means including carpentry work and as a scrap dealer. He became interested in theater early and by the age of sixteen, he had joined a travelling theater company. His striking good looks and ambition soon paved the way as a leading romantic actor in theater productions. In 1919, he attracted the attention of Max Reinhardt in Berlin who hired him as an actor for his productions. He started acting in German films in 1921 to make more money and quickly became a popular character actor. He tired of acting quickly and wanted to direct.

He directed his first film in 1923, Der Mensch am Wege, which co-starred a young Marlene Dietrich. Following that, he returned to acting for several years and appeared in such notable German films as Wachsfigurenkabinett (Waxworks) (1924) and F.W. Murnau's Faust (1926). In 1927, Dieterle and his wife, Charlotte Hagenbruch, formed their own production company and directed more films.

In 1930, Dieterle emigrated to the United States when he was offered a job in Hollywood to make German versions of American films. He adapted quickly to Hollywood filmmaking and was soon directing original films. His first, The Last Flight (1931), was a success and has been recently hailed as a forgotten masterpiece. Other films made during the 1930s include Jewel Robbery (1932), A Midsummer Night's Dream (1935), The Story of Louis Pasteur (1936), The Life of Emile Zola (1937), Juarez (1939) and The Hunchback of Notre Dame (1939).

Dieterle became a citizen of the United States in 1937.

During the 1940s, Dieterle works were infused with more lush, romantic expression and many critics see the films of this period as some of his best works. They include All That Money Can Buy (1941), Love Letters (1945) and Portrait of Jennie (1948).

Dieterle's career declined during the 1950s as a result of the McCarthyism period. Although he was never blacklisted directly, his libertarian film Blockade (1938) as well as some of the people he worked with were considered suspect. He did make a few films in the United States, including the 1952 film noir The Turning Point, as well as some films in Germany and Italy before retiring in 1965.

Dieterle is remembered as a tireless director of refinement and elegance who always wore a large hat and white gloves on the set.