Davies managed the club between 2008 and 2011 and has now become Forest's third manager this season.
"I'm delighted to welcome Billy back to our club and really look forward to working closely with him," chairman Fawaz Al Hasawi said in a statement.
"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."