Gordon Brown appointed Mr Mandelson Business Secretary in his most radical reshuffle since becoming Prime Minister.
His appointment was the most surprising element of a wider-than-expected shake-up that saw returns for other experienced Labour figures such as Margaret Beckett and Nick Brown.
None of the most senior posts were changed - Chancellor Alistair Darling, Foreign Secretary David Miliband and Home Secretary Jacqui Smith all remaining in their posts.
But John Hutton, who is making way for Mr Mandelson, was named Defence Secretary, with Des Browne leaving the Government altogether.
The transport brief, being vacated by Ruth Kelly who is also stepping down as an MP at the next election to concentrate on family life, goes to Geoff Hoon, previously Chief Whip.
No 10 also announced the creation of a new department, covering energy and climate change, to be headed by Ed Miliband, who moves from the Cabinet Office.
Having given up his parliamentary seat in 2004 to take up the post of Trade Commissioner, Mr Mandelson's return to Government is the latest remarkable twist in the career of a man who was twice forced to quit the Cabinet under a cloud.
It appeared to signal the end of a feud with Mr Brown dating back more than a decade to when Mr Mandelson supported Tony Blair to become Labour leader following the death of John Smith.
An ideal olive branch to Blairites, the appointment will infuriate many on the left of the party and has been greeted with astonishment by trade unionists.
In a wider-than-expected shake-up, there were also returns for Margaret Beckett as Housing Minister and Nick Brown, a close ally of the Prime Minister, for a second spell as chief whip.
Downing Street also confirmed that the present leader of the House of Lords, Baroness Ashton, was the Government's recommendation to Brussels to replace Mr Mandelson as a European commissioner.
Former foreign secretary Mrs Beckett and Mr Brown are among several new Ministers of State who will attend Cabinet.
Others are Home Office high-flyers Tony McNulty, who becomes Employment Minister, and Liam Byrne, who switches from immigration to the Cabinet Office.
Lord Drayson returns from a year off motor racing to be Science Minister.
Hilary Benn remains as Secretary of State at a slimmed-down Defra while Caroline Flint moves from the housing portfolio to become Europe Minister.
As television reporters rushed to give their analysis of Mr Mandelson's first words on his return to Government, he was asked one final question on why he was putting the Labour Party through this.
"You mean third time lucky," the politician, who became the first to quit the Cabinet twice, responded with a smile. "Thanks very much."
The Prime Minister's spokesman said: "Peter Mandelson is somebody who has a huge amount of experience dealing with trade and business matters, particularly at the European level.
"He is generally regarded to have done a good job as European Commissioner. He mastered a very complex brief."
The spokesman also confirmed that Mr Brown's controversial political "spin doctor" Damian McBride was being moved into a "more strategic role", working closely with Mr Byrne in the Cabinet Office.
He will be replaced by another No 10 aide, Justin Forsyth.
Jim Murphy becomes Secretary of State for Scotland, replacing Mr Browne who controversially held that post alongside his Defence brief.
Mr Browne said he was "extremely sad" to be leaving the MoD and that his admiration for the Armed Forces "knows no bounds".
He said he had told the PM he intended to step down next spring, understood the decision to remove him now and remained a "strong and loyal supporter" of Mr Brown.
Baroness Royall of Blaisdon takes over from Baroness Ashton as Lords leader and there will be at least two new faces on the Government benches in the upper chamber.
Being given peerages are Stephen Carter, the Prime Minister's strategy chief who will be junior minister for communications, technology and broadcasting and new City minister Paul Myners, the chairman of the Guardian Media Group and former chairman of Marks & Spencer who carried out a Treasury-commissioned review into institutional investment.
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