In a further shakeup of the team's front office, Kevin Pritchard was named general manager of the club, replacing David Morway who resigned on Tuesday.
"I'm going to take some time off and evaluate what I will do in the future," Bird, 55, said.
"This has nothing to do with any conflict or anything else, it's just time. I considered leaving last year, so this shouldn't be a surprise. I'm proud of what we've accomplished, I like the position this team is in, and with Kevin and Donnie, the basketball side won't miss a beat."
Bird, who said he might need shoulder surgery and has long-standing discomfort from old back injuries, is coming off a playoff season for the Pacers that earned him this year's NBA executive-of-the year award.
"I fully understand Larry's decision to step away and can't thank him enough for what he has done for the Pacers," said Pacers owner Herb Simon.
Bird coached the Pacers from 1997-2000 and took the team to the NBA Finals before returning to the front office.
Walsh, was franchise president for 20 years before leaving the Pacers in 2008 to serve as president of basketball operations for the New York Knicks for two years. Last season he served as a consultant with the Knicks.
"After discussing this with Herb and Larry, I'm very comfortable in coming back and doing whatever I can to help the Pacers continue their return to prominence in the NBA," said Walsh.
Pritchard joined the Pacers before last season as director of player personnel and was general manager of the Portland Trail Blazers 2007-10 prior to joining the Indiana club.
"This is a great opportunity," said Pritchard. "To be able to work with someone like Donnie Walsh...and to continue to build on what Larry has done here is a great honour."