The deal is worth $2.75 million and a source confirmed to ESPNNewYork.com it does not include a no-trade or no-movement clause.
"Evgeni has proven that he can still play at an elite level in the NHL," Islanders general manager Garth Snow said in a prepared statement. "He's given us a chance to win every night and we're excited to have him back for another season."
Nabokov said he's looking forward to the challenge of leading the Islanders back to the playoffs.
"I'm thrilled to commit to this team for next season," Nabokov said in the statement. "We have a great group in the locker room of young, talented players and we're heading in the right direction."
Although the 36-year-old famously spurned the Islanders last season, when he refused to report after being claimed by the team off waivers in January 2011, he has since flourished on Long Island and provided much-needed stability in net for the Islanders.
Nabokov, who is earning $570,000 this season, is 17-18-3 with a 2.56 goals-against average and a .912 save percentage in 40 games for New York, which has again been without No. 1 goalie Rick DiPietro for the majority of the season. Nabokov ranks 22nd on the NHL list -- and fourth among active goalies -- with 310 career wins, mostly while playing with the San Jose Sharks.
Contract discussions with Nabokov began prior to the Feb. 27 trade deadline. Although Snow received significant interest in Nabokov, he opted against trading him.
Nabokov had signed a one-year deal with Detroit, but the NHL's collective bargaining agreement states that anyone who plays in a professional league before signing an NHL contract must clear waivers. Nabokov, who played with San Jose for parts of 10 seasons, had spent last season with SKA St. Petersburg of the KHL.
He never played a game with the Red Wings.
Information from The Associated Press was used in this report.