Stackhouse had until July 1 to get out of the final two years left on his contract, which is worth around $15 million US.
The 28-year-old's new deal will begin when his current one ends, which will keep Stackhouse in Washington for the next four years and be worth nearly $33 million US.
"Re-signing Jerry was a priority and we are excited that he will be back in Washington," said Wizards general manager Wes Unseld. "This contract extension gives us stability at the shooting guard position."
Jerry Stackhouse inked a two-year, $18-million US extension.(AP Photo)
It was rumoured that Stackhouse would have opted out of Washington due to conflicts with coach Doug Collins and Michael Jordan.
However, Jordan left the team and Collins was recently fired and replaced by Eddie Jordan, who was the former assistant in New Jersey.
Stackhouse said that Eddie Jordan was a "major reason" that he decided to stay with the Wizards.
"This is where I wanted to be all along and I am grateful that the Wizards stepped up and made this commitment to me," said Stackhouse. "I have a great feeling about the direction in which this team is heading with Eddie Jordan and I look forward to being the leader that Mr. Pollin wants me to be."
The eight-year veteran, who was obtained from Detroit in exchange for Richard Hamilton one year ago, averaged 21.5 points and 4.5 assists per game this past season.
For his career, Stackhouse has recorded 21.3 points and 4.1 assists each outing.
"Jerry is going to thrive in our offence," said Jordan. "He attacks the rim and plays hard every night.
"He makes his teammates better."
