Townsend left Everton when his contract expired at the end of last season.
The 32-year-old has not played since suffering an ACL injury in March 2022 and recently saw a potential move to Burnley fail to materialise at the eleventh hour.
Townsend has played 264 Premier League games over the years for clubs including Tottenham Hotspurs, Newcastle United and Crystal Palace, and has chipped in with 25 goals and 28 assists.
“I feel like it’s a good fit and these last couple of weeks have been good for both parties,” Townsend, who will wear the No 30 shirt, told Luton's official website.
“I’ve seen where I can help this team and on the flipside the manager has seen where I can help – whether that’s on the pitch, in the dressing room or on the training field – with my enthusiasm and experience.
“Plus, Luton are my local team – I live 20-25 minutes away so I’ve kept my eye on their progress, and watching the Championship playoff final and see them win promotion was great for the club.
“I never thought I’d pull on the Luton shirt, so it’s a huge honour to play again in the Premier League for this club, and hopefully help this club get as many points as we can and see where it takes us.”
Luton lie 17th on the Premier League table after winning one of their first eight games.
“He’s been brilliant and his attitude has been phenomenal,” said the Luton manager, Rob Edwards.
“He’s a humble, hard-working individual that we will benefit from having at the training ground on a weekly basis. Young players are going to look up to him and think ‘they are the standards I need to be at’.
“Of course, he has had a difficult period with injury through no fault of his own and we wouldn’t be able to sign him if he’d had played in the last 18 months.”
Townsend has won 13 caps for the England national team.
