The Wolverhampton-born defender has been with the club since he was eight-years-old and now has committed his future to Wolves for four more years.
This latest loan move is the third of his career after successful spells with both Cardiff and Sunderland – but he will now play in the Championship again after joining Lee Bowyer's side.
With Cardiff the 21-year-old reached the Championship play-offs in 2020, before he was voted Sunderland's young player of the year by supporters last season.
He made his senior Wolves debut in 2019 against Villa in the Carabao Cup.
Wolves technical director Scott Sellars said: “Dion’s still very young, he’s only 21, a homegrown centre back with a lot of quality, and we want him to gain experience to hopefully come back and progress with us.
“Ultimately, there’s real value in loans and this is a prime example of it, if you can find the right club. We certainly thank Sunderland for giving Dion the opportunity and he came out of that period with a lot of confidence and improved as a player.
“It’s about getting an opportunity to play real football, there’s a progression through 23s, but we certainly feel the real value to a player comes from first-team experience, either here or somewhere else.
“Dion had a fantastic second part of the year at Sunderland, he really progressed. We wanted him to have the loan experience and kick-on as a player, which he did. Watching his performances, he really gained a lot of confidence and belief, and he attracted a lot of great publicity.
“He won Sunderland’s young player of the year, which was fantastic. We wanted him to progress, to try challenge him again. He’s getting close to full fitness and the opportunity to go to Birmingham and play Championship football was great for him and great for the club as well.
“We were very surprised nobody from the Championship came in for Dion after his spell at Cardiff. Sometimes that’s football, but credit to him, he got his head down, went to Sunderland and really challenged himself and this summer we had four or five offers from the Championship for him, so we’re delighted.”