The 33-year-old originally turned down offers of a new contract at the Calderon and was widely reported to be set for a switch back to Chelsea at the end of last season as a free agent, but the move failed to materialise.
"The Portuguese player will continue at our club for two more seasons after the agreement he has made," a club statement said.
Valencia were also interested in Tiago, who was a key member of Atletico's La Liga winning side last season, but he preferred to remain in Madrid, where he initially arrived on loan from Juventus in 2010, making the move permanent the following year.
"The club offered me the chance to stay. I feel proud because we had an incredible season and then I thought it was the right moment to move on. I had the chance to play in different international leagues," Tiago said.
"I took my time to look at the different options during the summer but when it came to making the decision, I felt that only with Atletico would I be sure of not making a mistake."
Tiago also denied rumours that he had walked away from the club on bad terms at the end of the last campaign.
"Over the weeks, a lot of false things have been written about me but that doesn't change anything," Tiago added.
"Since the end of the season, I did not forget about Atletico and neither did the club forget about me."
Tiago spent a season at Chelsea during Jose Mourinho's first stint at the west London club and also had spells at Braga, Benfica and Lyon. He ended his international career after the 2010 World Cup in South Africa.
(Editing by John O'Brien)
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