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The Brazilian was one of the favourites to succeed Grant in the Stamford Bridge hotseat but the timing of his appointment has come as a huge surprise.
Scolari is currently managing Portugal at Euro 2008 and was not expected to make a decision about his future until after the tournament.
Chelsea said in a statement: "Chelsea Football Club is delighted to confirm that Luiz Felipe Scolari will be the club's new manager from July 1, 2008.
"Felipe has great qualities. He is one of the world's top coaches with a record of success at country and club level, he gets the best out of a talented squad of players and his ambitions and expectations match ours.
"He was the outstanding choice.
"Out of respect for his current role as head coach of the Portuguese national team, and to ensure minimum disruption to this work, there will be no further comment from Chelsea FC nor from Felipe about his new role until his employment with us commences."
Despite a number of big-name managers being linked with the job following Avram Grant's sacking last month, PA Sport understands Scolari was always Chelsea's number one choice and there was never an agreement with anyone else.
He is likely to be unveiled during the first week of July, at which time the details of his contract will also be revealed.
Scolari's appointment comes less than a week after he insisted he would not discuss his future until after Euro 2008.
He said at the time: "What's going to happen to me after Euro 2008 - if I am going to stay or leave - concerns (only) me and I am not going to talk about it now.
"If I decide to leave or stay, I am only going to make a public declaration at the end of Euro 2008. If something else happens during the Euros, I am not going to answer although things may go this way or that way but I am here to work for the Euros.
"I started working for Portugal in 2004, then I signed up for 2006... I might sign again, I might leave the squad, I don't know."
Scolari's biggest achievement was leading Brazil to World Cup glory in 2002 and he famously turned down the chance to manage England following Sven-Goran Eriksson's departure in 2006.
The 59-year-old has no experience of managing at club level in Europe.
Before becoming an international manager, he enjoyed success at club level in Brazil, winning South America's equivalent of the Champions League - the Copa Libertadores - with two different clubs.
Portugal star Cristiano Ronaldo could come up against his current coach next season if Manchester United succeed in fending off the interest of Real Madrid but the winger does not begrudge the Brazilian ending his time in international football.
Instead, he respect's Scolari's right to move on - even though his presence is sure to galvanise Chelsea as they seek to put an end to United's two-season hold on the Premier League title.
"He needs to look for his future. I respect that," said Ronaldo, speaking after Wednesday night's match against the Czech Republic but before Scolari's appointment was announced.
"If he has better conditions, better things for the family and for him, I respect that.
"This is football, it's always like that. If he goes there it's going to be difficult. If he doesn't go there, another coach will do good work as well."
Former Chelsea midfielder Ray Wilkins described Scolari as "a manager of top quality".
He told Sky Sports News: "It appears that he's up for a challenge. He's a big guy, he's charismatic. This will be a breath of fresh air."
Stamford Bridge legend Ron Harris also welcomed the appointment.
"I think it's a top-class appointment," he told Sky Sports News.
"They have got a top-class manager."
Harris believes Scolari will introduce free-flowing football to Chelsea.
"When he was manager of Brazil their emphasis was on attacking style - I think he will bring that into Chelsea football club," he added.
The Portugal Football Federation later confirmed Scolari's departure.
According to the FPF website, www.fpf.pt, the Portugal players were informed of the decision minutes after the 3-1 win over Czech Republic in Geneva on Wednesday.
"Portugal Football Federation confirm that it has not renewed the contract of the national coach, given that Luiz Felipe Scolari has accepted an offer from Chelsea FC with effect from July 1, 2008", the statement said.
"FPF, particularly its president (Gilberto Madail), are thankful for the work and dedication of Luiz Felipe Scolari throughout his term, in which Portuguese football continually improved on the international stage.
"[FPF] understand that there are offers impossible to decline."
"Luiz Felipe Scolari thanks all support given by the Federation, stating that his personal decision was irreversible," added the statement.
"[FPF] President and the national coach [Scolari] carried out the gentlemen's agreement between them, and acknowledge that all technical staff, players and other members of the team will be focused to reach the objectives defined for the Euro 2008," the statement said.
"Gilberto Madail and Luiz Felipe Scolari will keep their friendship, which became stronger throughout the time.
"Given the superior interests of the national team, no-one will make any comment about this issue until the end of Portugal's participation in Euro 2008."
