The Brazil international had caught the attention of Liverpool but has decided to stay at his current club instead and extends his stay until the summer of 2018
The Brazil international had drawn the Reds' interest but Brendan Rodgers admitted on Saturday that the 25-year-old was unlikely to make the move to Anfield.
"I am delighted with this agreement after fighting a long time to win the respect and affection of the fans, the peers and people in the club. It's a very special moment, I am very happy here," Costa told the club's official website.
"I thank the club for making me this offer to spend much time here and hope to become a much bigger player and conquer all the objectives in front of us."
Costa scored 10 goals in 31 Liga appearances last season as Atletico finished third and lifted the Copa del Rey.