It is believed the seven-time world champion has signed for one year alongside compatriot Nico Rosberg and will be paid seven million euros (AUD$11.4 million).
The move will reunite Schumacher with team principal Ross Brawn, who was at the helm during his seven world titles at Benetton and Ferrari.
The 2010 season kicks off on March 14 with the Bahrain Grand Prix, around 10 weeks after Schumacher’s 41st
The F1 legend retired after the Brazilian GP in October 2006, having won 91 races from 250 appearances.
He was set to fill-in at Ferrari for the injured Felipe Massa this year but was kept out of the cockpit by his own neck troubles.
Ferrari President Luca di Montezemolo – who claims to have rekindled Schumacher’s passion for racing last year – is distraught about letting go of an icon of the sport and the brand.
But he admitted with Massa and Fernando Alonso already locked in for 2010 there was little he could do to prevent him signing with Mercedes.
Mercedes has been linked to young-gun Sebastian Vettel but he is contracted with Red Bull until the end of 2012, possibly opening the door for Schumacher to stay on for three seasons if all goes well next year.
His comeback is reminiscent of Niki Lauda who returned in 1982 after two years on the sidelines and went on to win his third world championship in 1984.
Schumacher still has a way to go however, if he wants to take the title of the oldest world champion off Juan Manuel Fangio.
The Argentine won his fifth title at 46 before retiring in 1958.