The 23-year-old right wing, who could have become a restricted free agent on July 1, had five goals and 15 assists last season -- his fourth in the NHL, all with New York. Okposo missed the Islanders' first 44 games after he tore the labrum in his right shoulder during training camp in September and underwent surgery.
He made his season debut on Jan. 20 against Washington and played in the Islanders' final 38 games.
Okposo was chosen by the Islanders with the No. 7 pick in the 2006 draft and he has become a key member of New York's foundation that includes fellow first-round picks John Tavares and Josh Bailey, and other forwards Matt Moulson, Michael Grabner and Blake Comeau.
In 192 career NHL games, Okposo has 44 goals and 72 assists.
He will earn $1 million next season, $2 million the following season, $3 million in 2013-14, $3.5 million in the 2014-15 season, and $4.5 million in the final year of the deal when the Minnesota native will be 28.
"Kyle has been a critical part of our young core over the past few seasons," Islanders general manager Garth Snow said in a statement. "He is a high character guy that brings size and a scoring touch to our lineup."
With this deal, Okposo -- an alternate captain the past two seasons -- could become a centerpiece player in the club's proposed new arena should approval be granted for its construction.
Islanders captain Doug Weight is expected to announce his retirement on Thursday, and Okposo could be a candidate to replace him.
"I'm very excited to commit to the Islanders for the next five years, especially with the news of the new Coliseum," Okposo said in a statement. "This team really showed its potential in the second half of the season last year and I'm excited to be a part of getting the franchise back to the playoffs."
The Islanders (30-39-13) finished last in the Atlantic Division for the fourth straight season and were 14th in the 15-team Eastern Conference. Only three of the NHL's 30 clubs had fewer points than New York, which will pick fifth in next month's draft after failing to reach the playoffs for the fourth consecutive year and fifth time in six seasons.