Butler, who is in the United Kingdom playing cricket, burst on to the international scene as genuine fast bowler but a serious back injury stymied his career.
During a long recovery he flirted with the idea of becoming a specialist batsman but is back bowling, although not at the pace he used to muster.
"We're delighted that Ian wants to come and play his cricket here," Otago coach Mike Hesson said.
"He'll certainly add a lot of strength and depth to our side.
"He is hoping the move to Otago will relaunch his cricket career."
Butler (26) has played eight tests for New Zealand, taking 24 wickets at an average of 36.83.
He took six for 46 in a losing effort against Pakistan at the Basin Reserve in December 2003, and his last test was against Bangladesh in Dhaka in October 2004.
He has also played 15 one-day internationals, taking 14 wickets at 39.85.
Butler has shown some promise with the bat, scoring two first-class 50s.
"We see him more as a bowling all-rounder. He still bowls a heavy ball even though he is not as quick as when he was young.
"But he is a far smarter bowler now and we see him as a guy who can bowl first or second change, and bat in the lower middle order."
Butler is expected to arrive in Dunedin in October and will play club cricket in the city.
Otago's 12 contracted players are expected to be announced through New Zealand Cricket early next week and Hesson hinted Butler would not be the only new name.
With Bradley Scott transferring to Northern Districts, Otago has been on the look-out for a quality bowler to replace him.
Hesson said the search had been successful but declined to comment further, other than to say he was a left-arm opening bowler.
Mat Harvie had his season ruined by a serious back injury last year but he is expected to come back into the mix.
The fast bowler will still have to prove his fitness but had a fine one-day season two summers ago.
Otago captain Craig Cumming could not be reached for comment last night but he is expected to return, and the middle order of Greg Todd, Neil Broom and Nathan McCullum are also likely to return for another summer.
Speedster James McMillan's injury-prone body is holding up and he is likely to be offered a contract, as is stalwart medium-pacer Warren McSkimming.
Otago players Brendon McCullum and Aaron Redmond have New Zealand contracts and free up spots for the likes of wicketkeeper Derek de Boorder and opening batsman Leighton Morgan.
Possible Otago contracted players: Derek de Boorder, Neil Broom, Ian Butler, Craig Cumming, Mat Harvie, Nathan McCullum, James McMillan, Warren McSkimming, Leighton Morgan, Craig Smith, Greg Todd, and one other.
