The Senegal international spent the whole of the 2004-2005 season on loan at the Reebok Stadium after a spell in the wilderness at Anfield, and his performances warranted a longer deal being offered.
Diouf moves back to the UEFA Cup competitors for an undisclosed fee and Bolton manager Sam Allardyce told the clubs official website that he is delighted and thrilled to have wrapped up his first, and possibly most important, signing of the close season.
"After months of negotiating with Liverpool and the player, I am thrilled that El-Hadji is joining us on a permanent contract. He has all the skills in the world to become one of our most significant signings in the modern era of this great club.
"Last season he was a revelation and no one more than himself relished the opportunity of resurrecting his career with us.
"We will give him the platform he needs to become one of Europe's top strikers again - that's how much confidence I have in the lad.
"He has had a turbulent last few years, but now he can take all that pressure off his shoulders and concentrate on playing football at the highest level."
The player himself played tribute to Sam Allardyce and the Bolton supporters for making him feel wanted, stating that his time at the club so far has seen him play his best football since he first moved to Lens in the late 1990's.
"It is wonderful news that I'll be joining Bolton Wanderers. Sam Allardyce is the best manager I've ever worked with. He makes you feel important and most of all lets you play football without worrying about anything else.
"Last season was my best spell for nearly five years and my time at the Reebok gave me an understanding that my career was going nowhere at Liverpool. I played with Bolton on a regular basis and helped them finish amongst the elite in the Premiership.
"The Bolton fans have made me welcome and are always chanting my name. As a player that makes you feel so proud and all you want to do is play to your best and not to let the fans down - they mean a lot to me."