The npower Championship club have announced McDermott, who was operating under a 12-month rolling contract, has committed himself to the Madejski Stadium until the summer of 2015. Wolves had identified McDermott as a potential candidate to replace the sacked Mick McCarthy but those hopes have now been dashed.
Reading, in a statement, said: "We are delighted to announce that manager Brian McDermott has this afternoon agreed a new contract to keep him at Madejski Stadium until the summer of 2015."
The statement continued: "Brian is one of the brightest managers outside the Premier League, and it is a major coup for the club to have secured his services for another three and a half years.
"Since the announcement of potential investment from Thames Sport Investment Ltd, securing Brian on a long-term contract has been one of Sir John Madejski and Anton Zingarevich's top priorities.
"With speculation this week linking our manager to the Premier League, the timing of this agreement is absolutely perfect for our club."
McDermott replaced Brendan Rodgers as manager in January 2010 after an initial successful caretaker spell which included a shock FA Cup win over Liverpool at Anfield.
McDermott steered the Royals to last season's play-off final, where they lost to Rodgers' Swansea, and they are making another strong promotion challenge this season.