The 48-year-old Scot replaces Alex McLeish, who left the club by mutual consent on Monday after just 40 days in charge.
He is the fourth manager to work under the club's Kuwaiti owners since they took control at the City Ground in July.
Davies' first spell as Forest boss began in January 2009 and saw him lead the club to successive Championship play-off campaigns before he was sacked in June 2011.
Former coaches David Kelly (who has left his role as Walsall assistant boss), Julian Darby and Pete Williams have also returned to the club and will work alongside Davies and current assistant manager Rob Kelly.
"It is a privilege and an honour to be back in charge of the Reds," Davies told the club's official website. "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.
"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."
Forest chairman Fawaz Al Hasawi said: "I'm delighted to welcome Billy back to our club and really look forward to working closely with him.
"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.
"We know the fans, players and staff will join us in welcoming Billy back to the Forest family. As I have said we will return Nottingham Forest to its former glory."
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