Sanderson was a huge success at St Andrews during the first half of last season, helping the Blues to seven clean sheets in 16 appearances.
He was then recalled by Wolves before spending the rest of the season at Queens Park Rangers
The versatile youngster has also enjoyed flourishing loan spells at Cardiff City and Sunderland and will be looking make another big impact for new boss John Eustace.
“This move is going to give Dion more exposure to a league he’s comfortable in and it’s so important young players gain good experience now," said strategic player marketing manager Matt Jackson.
"Once they can get themselves to 100 games at a certain level, they can be considered experienced, and that’s what we’re trying to do with Dion.
“He knows Birmingham well, obviously there’s new coaching staff there now, but he knows John [Eustace] from QPR.
"I have a relationship with John going back to my time at Watford, so I know him and the culture he likes at his football clubs.
"It completes the links, but ultimately, it’s really good for Dion’s development.”