Donnelly (35) has been appointed for the 2017 season and will come back from France to settle in Dunedin.
The 15-cap lock, who lost just one test in his time, will be the forwards coach and wants to move into coaching.
He is playing for Bayonne in the French Top 14 competition and will hang up his boots at the end of the season. He replaces Ben Herring, who moved to Japan at the end of last season.
Otago Rugby Football Union general manager Richard Kinley said the fulltime appointment was for just the one season initially and it would be reviewed at the end of the season. Kinley said there was a strong set of candidates for the job at the top end, who all had their strengths and brought in different skill sets.
"The key point of difference for Tom is that he knows the environment and he is up to date with the modern game. He has a massive history in New Zealand rugby," Kinley said.
"He has expertise in the set piece, specifically around the game and the way it is played in New Zealand."
Kinley said Donnelly had been carrying out a little bit of coaching in France and was also a senior leader in the Bayonne side. He was studying for a graduate certificate in sports coaching from the University of Canterbury.Donnelly knew the history of Otago and the set-up of the Otago union.
Kinley said the union was talking to set piece coach Keith Cameron about continuing his role but he was busy with his business and also coaching the Dunedin club side.
Otago head coach Cory Brown is the assistant coach of the New Zealand Colts this year and will be away for three weeks in June at the World Junior Championships in Georgia. Donnelly, who is married to Jacque with two pre-school children, will be back in Dunedin by then.
Donnelly was one of the best lineout forwards when he played and won his way into the All Blacks in 2009 on the back of his expertise at the set piece.
Originally from Bay of Plenty, Donnelly came south to study surveying and played 83 times for Otago, after debuting in 2002. He made his Highlanders debut in 2004, and ended up playing 65 games for the franchise.
He left after the 2011 season and played two seasons for the Crusaders before heading to the Blues in 2014.
After playing two seasons in Japan in the New Zealand off-season, he played his final season for Otago in 2013, when he was part of the Otago side which won the Ranfurly Shield.
Donnelly went to France after his season with the Blues in 2014.
