The 28-year-old, whose previous contract expired next summer, had been linked with a move away from the City of Manchester Stadium to either St James' Park or White Hart Lane.
But following talks with new manager Mark Hughes, he decided to stay at City until 2012.
Dunne: "My first priority is, was and always has been to stay at City because I've enjoyed it so much and I feel really settled here.
"When Mark Hughes got the job, I think everyone was really pleased and I was thrilled that he seemed to make it a priority to sort my contract out. I'm delighted to be able to stay."