The 40-year-old returns to his boyhood club, whom he helped win the Uruguayan top flight during the twilight of his playing career in the 2015/2016 season.
He also played in Argentina, Brazil, India and Japan during his playing career.
Forlan only announced his retirement from football in August but will now be taking his first steps into full time management.
"To me this is a huge joy, it's such an honour to be the person selected to be the leader of this project, of this club very important for me and for my family," Forlan told reporters on Friday.
"I'm very honoured and proud."
"Having travelled all over the world taught me a lot.
"How every country lives football, how the prepare for the day to day, how the cultural side affects the working tactics on the different teams. Then it's 11v11 inside the field but there are some things you have to realise that won't be the same in Japan, here in Uruguay or in Spain.
"I've learned a lot from all of them. I've learned a lot from the Spanish football, from the Italian football, from the Brazilian football. For me, that's an advantage of having travelled all over the world and being able to learn it.
"To experience it and adding things because I don't have a crystal ball, and neither do the Spanish or the Japanese. I think a bit of everything is important to do something better."
After failing to find his feet in England with Manchester United, whom he joined from Indepediente in 2002, Forlan revived his career in Spain with Villarreal, where he won the European golden boot in the 2004/2005 season.
Forlan transferred to Atletico Madrid in the summer of 2007 as a replacement for Liverpool-bound Fernando Torres, helping the Rojiblancos to the Europa League title in 2010.
Forlan played 112 times for the Uruguay national team, scoring 36 goals and was named as the best player at the 2010 FIFA World Cup in South Africa.
