The team didn't disclose terms of the contract, but the Cincinnati Enquirer reported that Newman received a two-year, $5 million contract.
Newman tweeted on Friday that he had agreed to return to Cincinnati and that he turned down a more lucrative offer from the Oakland Raiders to do so.
"After much time and thought, I'm heading back to Cincy. And for those of you who think it was about money, the Raiders offered more," he wrote.
Newman, 34, said his relationship with defensive coordinator Mike Zimmer, who also coached the cornerback with the Dallas Cowboys, helped him to decide to stay with the Bengals.
"I came in with Mike Zimmer and feel its only right that I leave as him coaching me. Thanks to Raiders Nation for showing me such love," he tweeted Friday.
The Cowboys drafted Newman fifth overall in 2003. Zimmer was the Cowboys' defensive coordinator from 2000-06.
Newman led the Bengals, who finished seventh in fewest yards allowed and eighth in fewest points allowed last season, in passes defensed (14) and had two interceptions, giving him 34 in his career.
"Terence has always had great talent, and he's become a smarter player every year of his career," Zimmer said in a statement from the team. "He sees things well and he challenges receivers. He's tough. He takes care of his body and doesn't miss reps. He's the kind of guy we want back as we work to keep our defense together."
Cornerback Adam "Pacman" Jones re-signed with the team last week on a three-year deal. Newman's return ensures the Bengals will have their top three cornerbacks, including Leon Hall, who agreed to a four-year extension in 2011, back in 2013.
"We've got a pretty good tandem going back there. The three of us like playing together. It's fun. One of us might be down one day, but the other guy picks him up," Jones recently told the team's website.