The 34-year-old lock is now expected to complete his career at his home province, with the deal confirming his ambitions to captain Ireland at Rugby World Cup 2015.
O'Connell is the latest Ireland player to spurn a move to the French Top 14 after Sean O'Brien rejected a lucrative offer from Toulon. Jamie Heaslip, the Irish No.8, remains the Irish Rugby Football Union's chief target to tie down to a new contract as the 30-year-old has fielded offers from Toulon and Montpellier.
"Over the years I have been privileged to play in many fantastic Munster sides," said O'Connell, who has made 154 appearances for the province. "As we build for the future I am excited by the prospect of playing my part in achieving success with Munster and Ireland in the coming seasons."