Allison will join the world champions in the newly created role of technical director and will lead their technical organisation. It follows the departure last month of Paddy Lowe, who has been widely tipped to join Williams.
“I am very excited to be getting back to work after this time away from the sport,” said Allison, who left Ferrari last summer.
“It’s a massive privilege to be given the trust of a position in a team that has done so spectacularly well in the past three seasons. I am really looking forward to playing my part in helping Mercedes go from strength to strength in the coming years.”
Allison will report directly to head of Mercedes-Benz Motorsport Toto Wolff, who will have overall responsibility for running the team.
Wolff said: “I am delighted to welcome James to Mercedes and very much looking forward to working with him.
“Our technical team is extremely skilled at every level and at the top of its game after delivering three world championships in a row.
“It wasn’t an easy task to find the right personality who can strengthen our experienced group of engineers, give our talented young team members the space to develop and also bring his own vision to this role.
“James is a sharp engineer; I think we have found the perfect guy and the right fit with our senior leaders.”