Shakespeare was appointed interim boss in March following the shock sacking of Claudio Ranieri – who he had previously been assistant to.
But he managed to turn the club’s fortunes around to set up a 12th placed finish.
The Foxes were facing a relegation battle when he took charge, but they won seven out of their 13 league games, while he also helped the club reach the Champions League quarter finals.
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 said: “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.”
His first battle as chief is likely to be deciding on Riyad Mahrez’s future – with the winger handing in a transfer request last week.
Arsenal, Chelsea and Monaco are interested in the Algerian, who is valued at around £40million, while there are worries at the King Power Stadium that there could be a mass exodus this summer.
Kasper Schmeichel has changed agents as Manchester United continue to be linked with a big money move for the Danish keeper, while captain Wes Morgan is being courted by Newcastle.
Shakespeare had previously followed Nigel Pearson around as his assistant – having two spells at the Foxes either side of a season at Hull.