Pellegrini succeeds the sacked Roberto Mancini, having guided Villarreal to the Champions League semi-finals and Malaga to the last eight in their debut campaigns in Europe's elite competition.
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Pellegrini told the club's official website: "I am delighted to accept this hugely exciting opportunity.
"The club has a clear vision for success both on and off the pitch and I am committed to making a significant contribution.
"Everything is in place for Manchester City to continue to be successful and I am excited to be able to work with such a talented squad, the executive team and the board to deliver for fans who are renowned for their steadfast support."
City chairman Khaldoon Al Mubarak added: "Manuel is a hugely experienced and successful manager with a proven track record."