The Argentine international had joined Atletico this July from Malaga. But Atletico would now sign Ajax defender Toby Alderweireld, 24, paving the way for Demichelis to leave.
City had lost their captain Vincent Kompany earlier who is out for more than a month due to a groin injury.
Demichelis had earlier played under City boss Manuel Pellegrini at Malaga and River Plate and also featured at the 2010 World Cup in South Africa.
Manuel Pellegrini, after taking charge at the Etihad Stadium in June, had already spent almost £90 million on four signings, with midfielder Fernandinho joining for £30 million, winger Jesus Navas arrived for £14.9m and strikers Stevan Jovetic and Alvaro Negredo costing £22 million and £20 million respectively.
City had suffered due to lack of defenders against Cardiff City when they lost 2-3 to the league new comers. Pellegrini hopes that bringing experienced Demichelis in the side would reduce their agony.