The 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.
"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.
The 50-year-old 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.
The statement from Reading added: "Both the club and TSI share the view that stability is an absolute cornerstone of success.
"This (contract) agreement shows the strides we are making now that TSI is on board, and the bright future ahead for our club.
"With a win percentage of close to 50%, Brian's record as our manager is nothing short of phenomenal.
"With 50 points from the last 25 games, his team are very well positioned in the npower Championship. The new contract reflects his track record and ability, and protects both him and the club for the long term."
Reading chairman Sir John Madejski said: "I am absolutely delighted that Brian has signed and this is a very, very important day for our club.
"Everybody knows how highly we rate him and he has more than repaid the faith we showed when we appointed him. He is a top manager.
"In the space of two years he has not only taken us to the play-off final and to two quarter-finals of the FA Cup, he has done so in a manner befitting Reading Football Club.
"He is extremely well respected by the staff, players and of course the supporters and I know this news will be very well received by our fans."
Madejski added: "From day one both myself and Anton wanted to secure Brian's services as it was only a matter of time before he was mentioned in connection with other clubs.
"These processes take time and we have today come to a fantastic agreement that puts our club on an even more secure footing going forward.
"With the team doing so well at the moment, it is truly a very exciting time to be a Reading fan and I for one cannot wait for the rest of the season."
McDermott's commitment to Reading was a second blow to Wolves after Alan Curbishley rejected a second bid from them to become McCarthy's successor.
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