The 51-year-old, nicknamed "Pyscho" for his fiercely passionate commitment, played more than 500 times for Forest between 1985 and 1997.
He briefly led the club as player-manager between December 1996 and May 1997.
"The honour of coming back to this club is massive for me," he said at his press conference at the City Ground.
He also said he hoped caretaker manager Gary Brazil wins promotion back to the Premier League by the time he takes over.
"I hope he does. I think it's for the greater good - it's not me or the chairman or the fans it's for the whole football club in general. We want to play in the highest league possible and if that happens this summer all well and good."
Forest, European champions in 1978 and 1979, have been outside the top flight for 15 seasons, but are pushing for promotion from the Championship despite sacking Billy Davies last month.
They are seventh in the second tier, two points off the promotion places with seven matches remaining.
Brazil has been in charge for the last two games and will remain in place until Pearce's arrival. Pearce is unable to take charge immediately because of existing personal commitments.
Before joining Forest in 1985 he played for Coventry City and after leaving he played for Newcastle United, Manchester City and West Ham United before spending two years as Manchester City manager from 2005.
He also managed the England Under-21 team and the British team at the London Olympics in 2012.
- Sports & Recreation