That takes him through to June 2017, along with coaches Ruben Cousillas, Xabier Mancisidor and Jose Cabello.
"We are delighted to reach this agreement with Manuel Pellegrini who has already contributed so much to the development of Manchester City in his first two years with us and we look forward to further progress in the seasons ahead," chief executive officer Ferran Soriano said.
Critics have suggested Pellegrini faced the sack if City did not regain the league title from Chelsea but the Chilean, who joined the club in 2013, believes they will have "a very good" season.
"I am proud to manage Manchester City FC and am therefore very pleased to have agreed this contract," he said.
"I have a very good group of players and a great team of people to work with on and off the field and at all levels of the club.
"I am focused on the coming season and confident that my team and I will respond to the constant support shown to us by everyone including of course our fantastic fans."
City start their league programme at West Bromwich Albion on Monday and play champions Chelsea in their first home game.
At a news conference on Friday, Pellegrini insisted that City must not only win a trophy but play in the style he wanted.
"A good season for a big team is that you must win a title," he said.
"If I'm not happy with the way we play, it's not a good season.
"So for me both things: firstly win, because we must win a title. Second, is to play in the way I like this team to play."
He agreed that City had fallen away badly in the second part of last season in dropping to fourth place before winning the final six games to finish runners-up to Chelsea.
"Last season was strange what happened after January. I hope this year we return to being a successful winning team. We were not a disaster defending last season but conceding 38 (goals) is too much – you can only afford 31 or 30 if you want to win."
Pellegrini added that he expects Sergio Aguero, Samir Nasri and David Silva to have recovered from a sickness bug in time for Monday's game.
(Reporting by Steve Tongue, editing by Amlan Chakraborty and Pritha Sarkar)
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