The 28-year-old had a successful loan spell at Atletico during the 2011-12 campaign, helping them win the Europa League, and has also played for clubs including Porto, Juventus and Werder Bremen.
"I am coming back to a club where I felt incredibly good," Diego said on Atletico's website on Friday, shortly before the end of the January transfer window.
"I am very happy to be part of such a strong group, one of the most in-form teams in Europe," he added.
Atletico are still challenging for silverware on three fronts this season.
They are joint top of La Liga with Barcelona and are through to the last 16 of the Champions League and the semi-finals of the King's Cup.
"It was only a matter of time before Atletico got to where they are now," Diego said. "I saw the club's potential when I was here last time."
(Reporting by Iain Rogers, editing by Justin Palmer)
