Panesar, who is currently in Australia with England's Ashes squad, initially joined the county on loan last season after hitting the headlines for the wrong reasons.
The 31-year-old left former team Sussex in August after he was fined by police for drunkenly urinating on doormen after being asked to leave a nightclub in the southern English town of Brighton.
However, his loan spell at Essex helped him secure a place in the England squad and he says he now owes the club a debt of gratitude.
"I will always remember how the supporters and members gave me a heart-warming round of applause when I first came on to bowl at Colchester last August.
"It helped me to feel respected and loved as a cricketer after experiencing a challenging time in my life."
Panesar told British newspaper the Daily Mail last month that he feared he had "thrown away" his England career following the incident in Brighton.
However, he finished the season in strong fashion by taking 14 wickets in his first six Essex appearances.
"We are delighted that Monty has decided to join our club," said Essex chief executive Derek Bowden.
"He liked his time here at the end of last season and we enjoyed having him.
