Structures and magnetic properties of Y(2)O(3):Co nanocrystals were investigated using high resolution transmission electron microscopy, x-ray diffraction, x-ray absorption fine structures, and superconducting quantum interference device. Cobalt atoms were found to be driven by thermal annealing from interstitial locations inside the Y(2)O(3) nanoparticles toward particle surface, where increased O vacancies surrounding Co atoms led to increased saturation magnetization. Our results strongly support a bound magnetic polaron model for ferromagnetism in diluted magnetic oxides mostly due to magnetic dopants located on the grain boundaries. (C) 2011 American Institute of Physics. [doi:10.1063/1.3544059]