The 36-year-old featured 28 times for Martin Jol's men last season following his free transfer from Panathinaikos.
Karagounis also scored two goals as the Cottagers finished 12th in the Barclays Premier League and will now stay in west London until the summer of 2014.
The Greece international, who holds the record for most caps for his country, was initially released by the Cottagers when the retained lists came out on June 7 and was linked with a return to Panathinaikos and a switch to Melbourne Victory in Australia.
But he will now spend a second season on the Thames where he was runner-up for the Fans' Player of the Season award last year.
Karagounis began his career with Apollon Smyrni, earning a move to Panathinaikos for the first time and then had spells with Inter Milan and Benfica before returning to the Greek capital.
He also played a vital role in helping Greece with Euro 2004, scoring the opening goal of the tournament against Portugal, and holds a record 125 caps.