That alerted the attention of Portsmouth, Newcastle and Tottenham but new City boss Mark Hughes has convinced the 28-year-old defender to sign an extension.
The Republic of Ireland international is already the longest-serving player in the City squad having joined from Everton in 2000 and has now committed himself to the club until 2012.
"I'm delighted to be able to stay," Dunne told City's official website.
"My first priority is, was and always has been to stay at City because I've enjoyed it so much and I feel really settled here."
Dunney is thought to have become disillusioned at City as the club dragged out Sven-Goran Eriksson's dismissal.But once the managerial situation was resolved and Hughes was confirmed as the new City boss, he was confident he would be staying.
"When Mark Hughes got the job I think everyone was really pleased and I was thrilled that he seemed to make it a priority to sort my contract out," Dunne added.
"As soon as he did (take over) we started to talk. It was literally a couple of days and it was all done and dusted.
"I'm pleased now that it's all been signed and sealed and I can relax a bit more now and concentrate on the season ahead."
Hughes will now aim to persuade young keeper Joe Hart to commit his future to the club by signing a new long-term deal.