The 38-year-old former Philadelphia Union man has been appointed by the Fire to replace Frank Yallop, who was sacked in September, and Brian Bliss, who acted as interim coach for the remainder of the 2015 season.
Paunovic, who led Serbia to the U20 FIFA World Cup title in June, was delighted to have been given a chance at senior level of a very competitive league.
"I want to thank Andrew Hauptman, Nelson Rodríguez and the whole executive team of the Chicago Fire for choosing me, among other great candidates, for the coaching position," Paunovic said in a club statement.
"I am very excited and enthusiastic to start working with the team, to meet the people and fans, who I know are very passionate and loyal to the club. This is the opportunity that I was looking for, to work with the right people, in the right time and the right place."
Paunovic, who played for the likes of Atletico Madrid, Tenerife, Getafe and Rubin Kazan during his career, added: "I have a huge amount of energy, knowledge and experience to deliver to our team and our community.
"Soccer is a lifestyle that I live and preach my whole life. I love this kind of challenge, where you have to build a champion by giving your best in every moment.
"I see the Chicago Fire as a hurt lion ready to unleash all its power."