The former Wales and Manchester United striker, 46, succeeded Roy Hodgson, who moved to Liverpool earlier this month.
"I am happy to have joined Fulham following much speculation regarding the appointment of a new manager," Hughes told the Fulham website.
Hughes, who had a glittering playing career which included a spell at Fulham's west London neighbours Chelsea, began his managerial career with Wales in 1999 and managed Blackburn Rovers before taking over at City in 2008.
Hughes has a tough act to follow at Fulham, where Hodgson made the most of the club's resources and took them to their first ever European final.
"I'm joining on the back of two of the most successful seasons in the club's history, and that in itself brings with it the challenges of expectation and ambition," said Hughes.
"I'm confident that with some additions to the squad, hard work and commitment, we can move this club forward in the right direction," he added.
Chairman Al Fayed was convinced Hughes could build on the club's success after Hodgson took them on an unexpectedly rewarding European adventure during which they beat Juventus.
"I am confident that with his Premier League and national team successes, Mark will be a great guy for the job," he said. "I know that he understands my vision for the club and believes in what we want achieve."
