The 66-year-old will return to the club where he won two European Cups as a player after his move was made official.
Ex-Republic of Ireland boss O'Neill could be joined by Roy Keane after Karanka quit just one year into the job.
A club statement read: "Nottingham Forest are delighted to confirm the appointment of Martin O’Neill as the club’s new manager.
"The Northern Irishman enjoyed a hugely successful playing career which included 371 appearances and 62 goals during a ten-year spell at The City Ground, a time in which he helped The Reds to win a First Division title, two European Cups and two League Cups.
"One of the original and most-loved ‘Miracle Men’, Martin is finally realising a life-long dream in managing his beloved Nottingham Forest.
Martin O’Neill’s managerial career
1987-89: Grantham Town
1989: Shepshed Charterhouse
1990-1995: Wycombe Wanderers
1995: Norwich
1995-2000: Leicester
2000-2005: Celtic
2006-2010: Aston Villa
2011-2013: Sunderland
2013-2018: Republic of Ireland
"With his commitment to the club, knowledge of the game and passion to succeed, O’Neill will be aiming to take the club back into the top flight of English football and make the miracle happen again."
On Friday, Karanka confirmed he was leaving the club and was released from his contract with his job already under threat.
Forest, who are now sitting four points outside of the play-off places in ninth, entrusted Simon Ireland to take over as caretaker for the weekend loss at Reading.
But former Aston Villa boss O'Neill has become the 11th boss at the club since June 2011.
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