UFC president Dana White announced the news via Twitter on Thursday.
"This is crazy but here we go again," White wrote. "You wanted it so you got it. Penn vs. Diaz."
Diaz was initially removed from the card during a Las Vegas news conference Wednesday. Not only had he not shown up to media obligations for the UFC, his long-time trainer Cesar Gracie admitted no one knew where he was and called his actions "a great disappointment."
Later that day, Diaz posted a video on YouTube titled, "Looks like someone don't want me to win," in which he appeared unapologetic for what happened while adding, "I'm ready to fight."
Diaz (25-7) vacated the 170-pound Strikeforce title in June to join the UFC. Prior to his release, he had successfully defended the belt three times. The 28-year-old fighter is a perfect 10-0 since 2008.
Although not a title shot, he still draws a high-profile fight against Penn (16-7-2). The former two-division champion hasn't fought since a somewhat controversial draw against Jon Fitch at UFC 127 in February.
The UFC 137 event takes place Oct. 29 in Las Vegas.
Brett Okamoto covers mixed martial arts for ESPN.com. Follow him on Twitter.