She said it was "abundantly clear" that the people of Hong Kong wanted universal suffrage by 2012 and said Tsang, as chief executive, should "take a much more robust stance".
Chan will stand in an upcoming by-election in one of the city's few openly contested seats.
The seat was opened up by the death of pro-Beijing politician Ma Lik.
Currently only half of Hong Kong's 60-member Legislative Council are chosen directly, with the other half elected by business elites from various sectors.
"For me this is a defining moment, an opportunity to put to the test all the values I hold dear," she told reporters on Tuesday.
"I have taken this decision only after the most careful consideration of the implications of my personal position, but more importantly, for my potential role in furthering the democratic good governance in Hong Kong."
"I need to put my money where my mouth is"
She said frustration with Hong Kong's slow progress towards full democracy had weighed on her decision, having previously ruled out running for office.
"I have come to the conclusion that you need political capital to make your voice more effectively heard," she said.
"I need to put my money where my mouth is."
As chief secertary Chan was head of Hong Kong's civil service before and after the handover from British rule. She was the first woman the first Chinese to hold the post.
She retired from office in 2001, but became a figurehead for the pro-democracy movement in Hong Kong in 2005 when she joined a march against an electoral reform package being pushed by the chief executive.
Hong Kong pro-democrats say Chan's decision to stand throws a political heavyweight into the by-election, which they hope will become a wider referendum on universal suffrage in the territory.
Full democracy was guaranteed in principle when Hong Kong was handed back to China by Britain in 1997, but it has yet to be introduced.