The Italian, who won the Premier League and FA Cup double with the Blues in 2010, takes the reins at the Bernabeu after leading Paris Saint-Germain to the French title last season.
Ancelotti's old job at PSG has been taken by former France manager and Manchester United defender Laurent Blanc.
Top boss: Carlo Ancelotti has swapped the Paris Saint-Germain hotseat for Real Madrid
At the double: Ancelotti poses with the Premier League and FA Cup trophies he won in 2010
'The Italian has experienced success in every country where he has managed and arrives in the Spanish capital after being named coach of the season in France.'
Madrid will present Ancelotti as their new coach on Wednesday afternoon in the Royal Box at the Bernabeu before speaking to the media.
Minutes after Ancelotti was announced as Madrid boss, PSG confirmed Blanc, who has been in talks with the club since last week, as his replacement in the French capital.
Wish you were there? Cristiano Ronaldo tweeted this picture with the message 'Enjoying the vacations'
Ancelotti's first job will be to convince Cristiano Ronaldo to stay at the Bernabeu.
The Portugal forward has been unhappy at Madrid and is wanted back at Manchester United, where Sir Alex Ferguson had been courting his former protege before his retirement at the end of the season.
Ronaldo even moved to dismiss reports that he had signed a new contract with Madrid earlier this month, suggesting a switch back to the Premier League could be close.
Pedigree: Laurent Blanc has previously managed the French national team
Connections: He spent two years at Manchester United winning the title in 2003
Ancelotti led PSG to the Ligue 1 title last term and Blanc, who achieved the same feat with Bordeaux in 2009, has been tasked with bringing further success to the club.
PSG also reached last season's Champions League quarter-final, losing on away goals to Barcelona.
And their statement continued: 'The board of Paris St Germain has given Laurent Blanc the mission to build on last season and to continue the club's ascendancy towards the summits of the European game.'
Blanc, 47, also lifted the Coupe de la Ligue and was named Ligue 1 manager of the year in Bordeaux's successful 2009 campaign before leading France into Euro 2012, where they suffered a quarter-final exit.
A distinguished career as a central defender was crowned by his key role in the France side which won back-to-back major trophies at their home World Cup in 1998 and Euro 2000, eventually retiring with 97 caps and an impressive 16 international goals to his name.
He also collected league titles in France with Auxerre and in England with Manchester United, the European Cup-Winners' Cup with Barcelona and domestic cup competitions with Montpellier, Auxerre and Barca.
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