The 28-year-old's future at the club appeared to be hanging in the balance due to the lack of progress over contract negotiations and the exit of Sven Goran Eriksson earlier in the summer.
Hughes' arrival and subsequent discussions with the Republic of Ireland international have made up his mind however, and Dunne has committed himself to the club until the summer of 2012, saying he never wanted to leave the club he joined in 2000.
"I'm delighted with it," Dunne told the club's official website upon the completion of his new deal.
"My first priority is, was and always has been to stay at City because I've enjoyed it so much and I feel really settled here.
"When Mark Hughes got the job I think everyone was really pleased and I was thrilled that he seemed to make it a priority to sort my contract out. I'm delighted to be able to stay."
City boss Hughes added: "I'm delighted with the outcome and Richard is a really important player for us.
"It was one of my priorities when I took the job that I made sure that he was one of the players we needed to keep."