The former Scotland international stunned the Stamford Bridge hierarchy by handing in his resignation when his old pal Gianfranco Zola joined the Upton Park club.
Chelsea were reported to have demanded up to £5million in compensation, but a deal was reached for what is believed to be a far lesser sum.
West Ham chief executive Scott Duxbury: "We are very pleased to welcome Steve Clarke to the club.
"Steve is rightly regarded as one of the top coaches in Europe and his experience and knowledge will be a huge asset to us."He recognises what we are trying to achieve at West Ham United and wants to be a part of that.
"We have worked very hard to bring him on board and are confident we now have the perfect coaching team."
Clarke spent 11 years as a player at Stamford Bridge from 1987 and returned to the club as a youth team coach following a short spell as Newcastle's assistant manager.