The Foxes had been in talks with Shakespeare since the end of the season last month and have now struck a deal after he took over on a short-term basis in February.
Shakespeare told the club's official site: "This is a really exciting opportunity for me to continue along this new path in my career and to continue to work with a club and a group of staff I've grown extremely close to. I'm grateful to the owners and the board of directors for their continued faith and support."
Shakespeare replaced Claudio Ranieri as boss until the end of the season after the Italian was sacked in February.
The 2016 Premier League champions were just a point above the relegation zone but Shakespeare won five straight league games to pull them away from trouble.
The Foxes eventually finished 12th with Shakespeare winning eight of his 16 games in charge in all competitions, losing five and drawing three.
He also helped them into the quarter finals of the Champions League, beating Sevilla 2-0 in their second round second leg to win 3-2 on aggregate.
The Foxes lost 2-1 on aggregate to Atletico Madrid in the last eight.
Leicester City vice chairman Aiyawatt Srivaddhanaprabha said: "Craig has shown all the qualities in leadership, motivation and talent management that are required to be successful in this role.
"Those qualities, aligned with his first class coaching acumen, his knowledge of Leicester City and its philosophy, and the respect he has earned at every level of the club make him the ideal choice to help take us forward.
"Our primary objective for the coming years is to successfully translate the extraordinary experiences of the last two seasons into lessons that will strengthen and enhance the club's pursuit of its long-term vision of sustainable success.
"Continuity is among the key elements to making such a process work. Over the last nine years, Craig has built a unique insight into the catalysts for success at Leicester City, its impact on our personnel and the conditions needed to ensure its longevity."
Shakespeare was part of ex-boss Nigel Pearson's backroom team during two spells at the King Power Stadium and stayed at the club after Pearson's exit in 2015.
He was Ranieri's assistant as the pair helped mastermind last year's shock title success after being 5/000-1 to win the league at the start of the campaign.
Shakespeare's biggest focus will be on summer recruitment with Riyad Mahrez reportedly wanting to leave the club and the Foxes linked with Swansea's Gylfi Sigurdsson.
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