Eutectic two-phase cells, also known as eutectic colonies, are commonly observed during the solidification of ternary alloys when the composition is close to a binary eutectic valley. In analogy with the solidification cells formed in dilute binary alloys, colony formation is triggered by a morphological instability of a macroscopically planar eutectic solidification front due to the rejection by both solid phases of a ternary impurity that diffuses in the liquid. Here we develop a phase-field model of a binary eutectic with a dilute ternary impurity and we investigate by dynamical simulations both the initial linear regime of this instability, and the subsequent highly nonlinear evolution of the interface that leads to fully developed two-phase cells with a spacing much larger than the lamellar spacing. We find a good overall agreement with our recent linear stability analysis [M. Plapp and A. Karma, Phys. Rev. E 60, 6865 (1999)], which predicts a destabilization of the front by long-wavelength modes that may be stationary or oscillatory. A fine comparison, however, reveals that the assumption commonly attributed to Cahn that lamella grow perpendicular to the envelope of the solidification front is weakly violated in the phase-field simulations. We show that, even though weak, this violation has an important quantitative effect on the stability properties of the eutectic front. We also investigate the dynamics of fully developed colonies and find that the large-scale envelope of the composite eutectic front does not converge to a steady state, but exhibits cell elimination and tip-splitting events up to the largest times simulated.