The 36-year-old fans favourite, who scored 59 goals in 377 appearances for the club across two spells, returns to Brockhall to work alongside lead coach and former team-mate Damien Johnson.
The pair progressed through the youth ranks at Rovers to play for the first team, before both moved on to Birmingham City.
During a distinguished playing career, Dunny helped Rovers win promotion to the Premier League in 2001 and the Worthington Cup a year later, as well as earning a cap for England against Portugal in September 2002.
He left the club last summer to join League One outfit Oldham, where he went on to gain valuable experience during a short spell as manager.
"I'm delighted to be back at the club,” said Dunny, who first arrived at Ewood as an eight-year-old and made his Rovers debut away to Everton in September 1998 at the age of 18.
“I don't have to say how much this club means to me. I think everyone knows what Blackburn Rovers means to me personally.
"So I'm just really looking forward to coming in and helping Damien. We have a good relationship anyway, so that should be fine and obviously I'm looking forward to learning from the manager (Paul Lambert), as well as Alan (Irvine) and Rob (Kelly), who are some of the best coaches around.”
Johnson, who made over 80 appearances for Rovers, returned to the club last year to take up a coaching position at the Academy, before being promoted to Under-21 lead coach in the summer.
The former Northern Ireland international said: “I’ve known David for over 20 years. We met as 14-year-olds when we were coming through the ranks together and we’ve got a really strong relationship, so I think it’s a brilliant appointment by the club and I’m really looking forward to working alongside him.
“He doesn’t need any introduction around these parts, he’s achieved everything that there is to achieve in the game, so he’s now going to pass that experience on. He’s going to be a great influence on the group and it’s up to the players to take advantage of that.”
Rovers’ Head of Academy, Eric Kinder, said: “I’m absolutely delighted David has accepted the role to work alongside Damien with the Under-21s.
“It’s important that we recruit staff with a love of the club and I certainly don’t need to tell people how much David loves this club.
“I have been really impressed with how he has gone about getting his coaching qualifications in recent years, whilst continuing his playing career, which shows just how focused and determined he was to go down this route.”