The 23-year-old, who had been linked with moves to Manchester United, Liverpool and Arsenal, will now remain at the Mestalla until the summer of 2015.
"I would like to thank the club for giving me the opportunity to continue here and gain more years playing in this team," Banega told the club's official website.
"I have already been at the club for a few years and am very happy. I hope to continue in the same manner."
Banega joined Valencia in 2008 from Boca Juniors.