A statement on the Reading website said the Scot was their first choice for the role as he takes over a side sitting in 16th in the division, seven points above the relegation zone, and 10 points behind the play-off places.
Prior to entering management with West Brom - who he lead to an eighth place finish before being dismissed a year ago - Clarke worked under Jose Mourinho at Chelsea and Kenny Dalglish at Liverpool.
Clarke said on his appointment: “I am absolutely delighted to be joining Reading Football Club and I look forward to helping the club move in the right direction. A big part of the work ahead is on the training ground and I look forward to meeting the players and getting onto the grass with them. There is real potential here and hopefully exciting times ahead for the supporters.
Clarke added at a press conference that he has a squad that is capable of competing in the Championship, and hopes he can bring success to the club as soon as possible - with ambitions of taking the club back to the Premier League.
It has been a quick appointment with Nigel Adkins only sacked yesterday after the 6-1 defeat to Birmingham City on Saturday.
Clarke said: "It's been very, very quick. The good thing for me is that I was their preferred candidate, and the good thing for the club was that I was out of work."
Co-Chairman Sir John Madejski said that Clarke has a CV of the highest order, speaking of his delight that Clarke has signed a two-and-a-half year deal at the club.
He added his best wishes to Adkins, saying: "Nigel Adkins worked tirelessly to achieve success, sadly it did not work out for him but we wish him, his family and staff well for the future. Now we look forward to a new era under Steve’s stewardship and I for one am excited about this new beginning.”