For Paul, 33, and the Rockets, this deal sets them together on a path to try to unseat the Golden State Warriors in the Western Conference.
Paul never considered leaving the Rockets in free agency, league sources said.
Paul, a nine-time All-Star, and MVP James Harden elevated the Rockets to the best record in the NBA (65-17) this season before losing a seven-game series to Golden State in the conference finals.
The Rockets acquired Paul a year ago in an opt-in-and-trade deal with the LA Clippers.
In addition to Paul, swingman Gerald Green agreed to re-sign with the Rockets on a one-year deal for the veterans minimum of $2.4 million, a source told ESPN. Green averaged 12.1 points last season and had five games of 20-plus points off the bench last season.
The Associated Press contributed to this report.