The Croatia international joined Los Blancos from Tottenham in 2012 and initially struggled to justify his reported £32 million transfer fee.
However, last season he proved himself as one of Madrid's most reliable performers, playing a key role in their Champions League and Copa del Rey triumphs, and has now been rewarded with an extension, which runs until 2018.
“I’m very happy," Modric told his club's official website. "Today is an important day for me.
"I’d like to thank the club and president Florentino Perez for the confidence they have placed in me. I would like to return that confidence by giving my best in the coming years.
“When I came to Real Madrid, all my dreams came true. These years have been magnificent, I have enjoyed every moment and I’ve had fun.
"In the coming years, I’m going to give even more. My dream continues with my renewal. I hope we can win many more titles in the years to come."
Indeed, having already lifted the Uefa Super Cup this season, Modric is now hoping to help Madrid claim the second of their six trophy targets for 2014-15 by overcoming city rivals Atletico in the second leg of their Supercopa de Espana tie at the Vicente Calderon on Friday night, having drawn the first tie 1-1.
“When I arrived here two years ago, we won the Supercup of Spain," he mused. "It was my first match. Hopefully we can win another Supercup in Atletico’s ground.
"I’m feeling really confident and it would be very significant to start the season by winning another title after the European Super Cup. We’re going to give our all to bring more satisfaction to the club."