The 35-year-old, who was on loan at Millwall from QPR, will immediately make the switch to Meadow Lane ahead of Saturday's trip to Hartlepool United in the first round of the FA Cup.
Derry was born in Nottingham and joined County as a 10-year-old, before spending three years at the club at the beginning of his senior career.
The central midfielder moved to Sheffield United in 1998 and has also represented Portsmouth, Crystal Palace, Nottingham Forest and Leeds United.
Derry will be supported by assistant Greg Abbott, who was sacked by Carlisle United in September.
Notts County chairman Ray Trew said that the board had faith in Derry, despite his inexperience.
"Shaun is someone who can relate to the players and, perhaps more importantly, relate to this club, but he is not naïve enough to think that he could take this step alone," Trew told the club's official website.
"That is why he has turned to Greg Abbott, a man with a wealth of experience in the Football League, as a coach and manager, and someone that he was worked with in the past, to assist him in his new role.
"There are question marks over his (Shaun's) credentials, simply because this will be his first managerial role. I know that, but there are doubts with every managerial appointment.
"Having met with them both (Derry and Abbott) at length I am confident that they have what it takes to not only turn our fortunes around this season, but to go on and deliver the success and stability that we are craving here at Meadow Lane."
Notts County sit bottom of the League One table, three points adrift of safety.
