The 35-year-old battling defensive midfielder beat off competition from caretaker boss Gerait Williams, former Port Vale coach Mark Grew and another mystery applicant.
Parkinson admitted that he was pleased to be starting his first job as a manager. Speaking to Colchester United World he said: "I am delighted to get the job. When I first met the chairman I had an open mind but the more I spoke to him the more I became interested in the club and impressed with what is already in place.
"One of the most important things about the club is that it is financially stable, and that sets it above a lot of clubs in the Football League. First of all I want to move this club forward professionally.
"I want to make sure the club play with more passion, commitment and spirit."
The Essex club currently lie eighteenth in Division Two, just two points clear of the relegation zone.
The Layer Road job is his first as a manger. Parky, who has barely featured in the first team this season, has been tipped by many for a highly-prosperous career in management.
Colchester United director Peter Powell revealed that the decision wasn't an easy one to make even though the Royals man was well recommended.
"It was perhaps the hardest decision the board has had to make in my time I have been a director at Colchester United," said Mr Powell, speaking to the Official Colchester United site.
"There was a time when Sir Alex Ferguson had little managerial experience and while Phil may not become as successful as the Manchester United manager we feel that he has the right attributes to take charge of football at Colchester United and take the club forward.
"He has been highly recommended by the people at Reading, the people at the Football League and other individuals within football."
Gerait Williams, who has taken temporary caretaker charge as the U's have risen clear of the Division Two relegation zone, will be Parkinson's assistant.
Royals fans were understandably disappointed to see the legendary figure depart but it has been clear for some time now that his playing career has been coming to an end.
In recent months the Chorey-born man has been involved in ever-increasing amounts of coaching, regularly taking charge of the Royals reserve team. The 35-year-old is well qualified for his new role, already possessing a UEFA A coaching badge.