Kelly, who has the longest tenure of any major league manager, led the Twins to World Series titles in 1987 and 1991, but in recent years has led Minnesota through eight straight losing seasons.
He met Tuesday with Twins president Jerry Bell before the extension was announced.
"He is without a doubt one of the finest managers in the game today and we are extremely pleased to have him leading our club," Twins owner Carl Pohlad said.
Kelly, 50, has guided the Twins since Sept. 12, 1986, when he replaced Ray Miller.
"I believe our team is greatly improved and we look forward to continuing our efforts in building a competitive ballclub," Kelly said in a statement.
A native of Graceville, Minn., Kelly nicknamed "TK" began his relationship with the Twins as a minor league player in 1971.
Kelly has a 1,055-1,167 career record but is 529-709 during the past eight seasons.
Though few have questioned Kelly's ability to manage, some players raised doubts as to whether he was the right man to handle the youthful Twins.
Doug Mientkiewicz, a U.S. hero at the Olympic Games, said his stint with the Twins was like "walking on eggshells." Todd Walker, the Twins' top pick in 1996, struggled under Kelly and criticized the way he handled young players.
"I think Kelly can go to the extreme when he talks about what a guy can or can't do," Walker said after he was traded to Colorado in July. "Especially what he can't do. I think ultimately I consider the source."
Kelly had said in recent days that he wanted to continue managing the Twins, though only if he had management's support. The team has a strong base of starting pitchers (Brad Radke, Eric Milton and Mark Redman) and some promising young players (shortstop Cristian Guzman and outfielders Matt Lawton, Torii Hunter and Jacque Jones).
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