The 31-year-old, currently in Australia with the Ashes squad, agreed the deal after making a loan move to the county midway through last season following a troubled summer both on and off the field.
Panesar left former county Sussex in August after he was fined for drunkenly urinating on a bouncer after being asked to leave a nightclub in Brighton.
Essex subsequently offered the spinner his loan deal, which helped him secure a place on England's Ashes tour, and the veteran of 48 Tests said he was ready to repay the county for their faith following a "challenging time" in his life.
"I loved playing for Essex last season. In the short time I was there, I was made to feel very welcome, both in the team and around the club," Panesar said in a statement from the club.
"I will always remember how the supporters and members gave me a heart-warming round of applause when I first came on to bowl at Colchester last August.
"It helped me to feel respected and loved as a cricketer after experiencing a challenging time in my life.
"I am determined to play my part in inspiring the team to be successful in all competitions.
"I want to help the club build towards the kind of success they enjoyed in its glory days under legendary captains Keith Fletcher and Graham Gooch.
"I love the 'family feel' of the club, and value the role Essex has played in helping me move towards my best, and gain selection for this winter's Ashes Series."
A repentant Panesar told the Daily Mail last month that he thought he had "thrown away my England career" following the incident in Brighton.
Panesar was overlooked for the final Ashes Test at the Oval last summer, with Simon Kerrigan preferred for what was to prove a chastening debut.
To compound Panesar's embarrassment over the incident, a video of his pursuit by bouncers emerged on the internet a few days later.
But he responded by taking 14 wickets in six appearances for Essex to earn his Ashes call.
"We are delighted that Monty has decided to join our club, he liked his time here at the end of last season and we enjoyed having him," Essex chief executive Derek Bowden said.
"He was on top of our list for new players and it's great to finalise his signing in good time for next season."