Favre took over last summer and his side led the Bundesliga for a large part of the season, competing with Bayern Munich for the title until the 34th match of the season.
The club also won their Champions League group before being knocked out by eventual finalists Tottenham.
The 61-year-old told the club website: “I am looking forward to continuing a constructive and successful cooperation with the entire BVB team.”
The club’s chief executive officer Michael Zorc added: “He has met the expectations to 100 per cent. It is logical that we have the future we want to shape together.”
