Nottingham-born Derry first joined the club as a 10-year-old and began his professional career at County in 1995. He spent three years at Meadow Lane before moving to Sheffield United in 1998.
Experienced former Carlisle United manager Greg Abbot has also joined the club and will serve as assistant manager to Derry as he takes his first managerial steps.
Notts County chairman Ray Trew revealed his surprise when the former Portsmouth and QPR midfielder contacted him to express his interest in becoming the club's new manager.
"When we, as a Board, sat down to identify the credentials that we were looking for in our next manager, we were agreed that we needed someone who understood this club and what it means to our fans," Trew told the club's official website.
"I have to be honest and admit that Shaun wasn't someone that we had thought of initially, but that was only because he was still enjoying a successful career as a player at a higher level.
"However, when he contacted me to declare an interest in the position, he was an applicant that we simply couldn't ignore.
"What he has achieved as a player, coupled with the leadership that he has shown throughout his career, make him the ideal candidate for a managerial role and he made it clear that he wanted that role to be with his hometown club."
Trew played down fears a lack of experience may hinder Derry, stressing Abbot's presence at the club will be vital for the 35-year-old.
"There are question marks over his credentials, simply because this will be his first managerial role, I know that, but there are doubts with every managerial appointment and we, as a Board, have to put our faith in who we think is the right man for the job," added Trew.
"Shaun is someone who can relate to the players and, perhaps more importantly, relate to this club, but he is not naive enough to think that he could take this step alone.
"That is why he has turned to Greg Abbott, a man with a wealth of experience in the Football League, as a coach and manager, and someone that he has worked with in the past, to assist him in his new role.
"Having met with them both at length I am confident that they have what it takes to not only turn our fortunes around this season, but to go on and deliver the success and stability that we are craving here at Meadow Lane."