The 48-year-old Scot replaces his fellow countryman Alex McLeish at the helm, who left the club on Tuesday after just 40 days at the City Ground.
This will be Davies’ second stint in charge of Forest, whom he twice led to the play-offs during his two-and-a-half-year stint between 2008 and 2011.
A season of turmoil
||Sean O'Driscoll sacked
||Alex McLeish exits
"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 per cent - 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."
Davies, who holds the record for the most Championship manager-of-the-month awards, led rivals Derby County to the Premier League in 2007 and says yjsy his aim is to return the club "to its former glory".
"It is a privilege and an honour to be back in charge of the Reds," he enthused. "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."
Davies will take charge of the team from Monday and will be in the dugout for the home game against Bolton the following Saturday.