"I am very happy to join West Bromwich Albion for the next two seasons," Lugano said on his Twitter feed.
British media said the fee was one million pounds ($1.53 million) for the 32-year-old, who has 85 caps and helped Uruguay win the 2011 Copa America.
He had spent the last six months on loan at Malaga after failing to make an impact at PSG where he played only 12 league games in 18 months after joining from Fenerbahce in 2011.
Lugano is Uruguay's second-highest capped player and has captained his country 77 times - more than any other player.
He is West Brom's third close-season signing with the club having secured French striker Nicolas Anelka on a permanent deal and Macedonian fullback Goran Popov on another season-long loan.
"This is a tough league. You need as many good players in your squad as you can get - and Diego is undoubtedly one of those," West Brom manager Steve Clarke said on the club website (www.wba.co.uk).
"He has a real hunger and ambition to play and succeed in the Barclays Premier League and he will hopefully get a platform here to show everyone what he can do.
"However, Diego knows he's got a fight on his hands to get into the team."
West Brom finished eighth in the standings last season and begin the new campaign at home to Southampton on August 17. ($1 = 0.6548 British pounds)
(Writing by Gregory Blachier in Paris and Toby Davis in London; Editing by Ken Ferris)
