The 26-year-old Brazil international started his career with Santos before moving to Europe with Porto in 2004. He joined Werder Bremen in 2006, then spent the 2009-10 season in Italy with Juventus before returning to Germany with Wolfsburg.
Wolfsburg coach Felix Magath said on his club's website: "I'm convinced that Diego will play a key role in Madrid. I wish him all the best."
Meanwhile, Atletico confirmed the transfer of Brazil midfielder Elias Mendes to Sporting Lisbon.
The 26-year-old international joined Atletico from Corinthians during last season's winter break and played 16 league and cup matches for the Rojiblancos.
Mendes has agreed a five-year contract with Sporting and will cost the Portuguese club just under nine million euros.