The news comes at the end of a promising first season with the club, during which 61-year-old Favre’s side thrilled fans and neutrals alike with their attacking football and assault on the Bundesliga title.
It was the closest German title race in years, with Dortmund leading for much of the opening phase of the season – though they were eventually pipped by two points by Bayern Munich.
"Lucien has created clear structures and developed our players," sporting director Michael Zorc told the club’s website.
"He has met our expectations 100 per cent," added CEO Hans-Joachim Watzke. "It is logical that we want to shape the future together.”
With Paco Alcacer and Marco Reus topping the goalscoring charts with 35 league goals between them, perhaps the most pleasing aspect of Favre’s reign so far has been his commitment to the club’s talented young players.
England’s Jadon Sancho has taken the headlines, but the likes of Jacob Bruun Larsen, Manuel Akanji, Achraf Hakimi and Dan-Axel Zagadou have also played key roles.
Fans will therefore be hoping that Favre’s first season was only the beginning – a tantalising prospect given their showing this campaign.
"I am looking forward to continuing my constructive and successful cooperation with the entire BVB team," the Swiss Favre said.
His commitment to youth long precedes his time with Dortmund – he was the manager who first brought through Reus in his Borussia Monchengladbach days.
Favre will hope that disappointment proves a learning experience for his young charges, with their attacking style seemingly well-suited to the modern Champions League.
Their European experience could be added to in the coming weeks, with Dortmund heavily linked with a move for former defender Mats Hummels.
Hummels left Dortmund for Bayern in the summer of 2016, going on to win three successive Bundesliga titles, a German Cup and three German Supercups.