Balshaw, 27, will return to the west country following a 106-game Premiership career with Bath before he joined Leeds in 2004.
He becomes Gloucester's third international recruit for next season, following Italian forwards Marco Bortolami and Carlos Nieto.
Balshaw, capped 24 times and a member of England's World Cup-winning squad, has seen his career ravaged by injuries during recent seasons.
But he is a strong contender to tour Australia with England this summer and moves to Gloucester following a difficult campaign when Tykes suffered relegation from the Guiness Premiership.
"I am really excited to be joining one of the true powers of English rugby," said Balshaw.
"I have been hugely impressed by their play this season and when I met with Dean Ryan (head coach) I was left in no doubt about their vision for next season and beyond.
"Gloucester are a club with massive potential which can only grow for the Europen Cup next season."
Gloucester's emphasis on youth during the latter half of this season saw players like England under-21 fly-half Ryan Lamb and centre Anthony Allen emerge into the Premiership spotlight and, with Balshaw operating from full-back or wing next term, there should be no let-up in entertainment value at Kingsholm.
"We have made clearly defined and outstanding progress with a group of youngsters this season that has been hugely positive but alongside that we felt we needed some experience, and Iain Balshaw has plenty of that," said Ryan.
"It is a signing I am thrilled about because Iain is a wonderfully expressive and dangerous runner.
"As a British Lion and England international, he will also be a tremendous influence on the young group of backs already making their mark.
"We have made significant additions in other areas of the squad, and Iain's arrival once again signals our intent for a season when we will be back in the Heineken Cup."
Balshaw made his England debut during the 1999/2000 season, toured Australia with the 2001 Lions and went on as a replacement in the 2003 World Cup final after scoring a try during England's hard-fought pool victory over Samoa.
He last played for his country in the Calcutta Cup victory against Scotland at Twickenham 14 months ago.