The Swedish international has been a key figure in Albion establishing themselves in the Barclays Premier League.
Olsson told West Brom's official website: "It's been a long process but it's done now and I'm very happy.
"I had a few things that were important to me and there were some issues that were important to the club.
"Finally we came to an agreement and I'm very happy. The boss was a key factor for me.
"I really enjoyed playing under Roy Hodgson. The new gaffer has picked up where he left off and, in addition to that, has brought in some very interesting ideas.
"I really enjoy his way of thinking about football.
"He's a very nice person and he's been brilliant over these last couple of months, which has made my decision easier.
"He has been respectful to me about making my own decision."