The 20-year-old, who spent the second half of last season on loan with Scottish giants Rangers, will now link up with the Black Cats for the 2022-23 campaign.
Diallo becomes the first signing made by newly-appointed manager Tony Mowbray, who took the reins in the North East on Tuesday following the departure of Alex Neil to Stoke City.
The Ivory Coast international is also the club's seventh signing of the summer window after the arrivals of Dan Ballard, Jack Clarke, Aji Alese, Alex Bass, Jewison Bennette and Edouard Michut.
Speaking to Sunderland's official website on his arrival at the Stadium of Light, Diallo said: "I feel good and very positive about this opportunity, so I'm happy to be here.
"It was a great experience to play with Manchester United, but I'm here for a new challenge and I want to try my best to bring a lot of success to the club.
"I feel good physically and I think this is the best team for me to progress and although I've never been to the Stadium of Light before, I know the supporters are great so I hope we can win many games together."
Since joining Man United from Atalanta BC in a deal worth up to £37m in January 2021, Diallo has only featured nine times for the senior side in all tournaments.
The youngster's only goal in a competitive match for the Red Devils came in a 1-1 draw against AC Milan in the last 16 of the 2020-21 Europa League, while he also found the net in last month's pre-season friendly draw with Rayo Vallecano.
Diallo made just one appearance for United during the first half of last season before joining Rangers on a temporary deal.
The Ivorian scored just four minutes into his debut for the Glaswegian giants and went on to net another two goals in 13 appearances.
Diallo could make his debut for Sunderland when they travel to the Riverside Stadium to face Middlesbrough in the Tees-Wear derby in the Championship on Monday night.
United have now let four young prospects leave the club and join Championship clubs on loan this summer, with Ethan Laird moving to Queens Park Rangers, Alvaro Fernandez linking up with Preston North End and Hannibal Mejbri signing for Birmingham City.