The Uruguay striker will remain with the club until the summer of 2013, signalling his intent to see out his career in the Spanish capital.
Forlan, who was Europe's leading goalscorer last season with 32 goals, was delighted to secure his future with Atletico.
"I'm very happy with the renewal. I've always said, since I arrived at this club, that I was very happy and that it was my hope to stay at Atletico for many years," he told the club's official website.
"It's a dream to be able to extend my contract for two more years. I'm convinced that we can obtain titles in this time."