Davies and his representatives were in negotiations with Forest chairman Fawaz Al-Hasawi on Wednesday at the Championship club.
The 48-year-old Scot was dismissed by the Reds' old regime in June 2011.
“It is a privilege and an honour to be back in charge of the Reds. As my new friend Fawaz says I have unfinished business here at Forest and am relishing this great opportunity to return Forest to its former glory," said Davies.
“My tenure at the City Ground was cut short last time and I can’t wait to get my boots back on and training the lads. We have a great squad and I know I can get the best from them. Coming home to The Reds is a dream come true."
After steering the club away from relegation following his appointment in January 2009 and then masterminding successive play-off campaigns during his first spell at the City Ground, Davies is on record as stating that he has "unfinished business" at the club.
Davies remains popular among Forest fans and the Al-Hasawi family, the club's Kuwaiti owners, are keen to win over supporters following the turbulent start to their tenure.
The Al-Hasawis are making their third managerial appointment since completing their takeover in the summer.
They began by sacking Steve Cotterill, who had just saved the club from relegation, within days of their arrival.
Sean O'Driscoll, who coached under former boss Steve McClaren, was brought back as number one but sacked on Boxing Day after a 4-2 home win over Leeds which left the Reds just one point adrift of the play-off places.
The surprising decision to sack O'Driscoll was followed by the Kuwaiti's stating their intent to appoint a manager with Premier League experience.
Former Birmingham and Aston Villa boss Alex McLeish was hired the next day but the Scot, after a brief 40-day tenure, left on Tuesday amid rumours of interference in team affairs from the owners.
“I’m delighted to welcome Billy back to our Club and really look forward to working closely with him," said chairman Fawaz Al Hasawi.
“Billy has unfinished business with the Reds and we know how hungry he is for success. In returning to the City Ground we believe his leadership will help us fulfil our ambition of making it to the Premier League.”
“Billy is a Forest legend who needs no introduction to our loyal fans. We know how excited he is to pick up where he left off last time and we will back him 110%, - this is a very exciting appointment for us."