Forlan has long been a fan of the club where his father Pablo won the Libertadores Cup and Intercontinental Cup in the 1960s.
"With a surname linked to the club's history, son of a champion of the Americas and the world with Penarol, Diego will wear the yellow and black as he did when he was a boy and dreamt of being a professional footballer," the club said.
Forlan was capped 112 times for Uruguay and voted the best player at the 2010 World Cup when Uruguay reached the semi-finals.
The 36-year old recently left Japanese club Cerezo Osaka. He had previously spent time at Independiente of Argentina, Atletico Madrid, Manchester United and Brazil's Internacional, amongst others.
Uruguayan media said he would make his debut on Aug. 8 in a friendly against an unnamed Argentine side.
Penarol did not reveal details of his contract but local media said he signed an 18-month deal.
(Reporting by Andrew Downie, editing by Mitch Phillips)
