Denilson made 37 appearances for the Brazilian club last season after being granted permission to leave the Emirates Stadium in search of first-team football.
Director of football Adalberto Baptista was dispatched to Europe last week to hold talks with the Premier League club regarding an extension and has secured Denilson for another year.
His loan will now expire on June 30, 2013.
"I'm very relieved," Denilson told the club's official website. "I am very happy. Now I will be focused on bringing titles to Sao Paulo."
Denilson, 24, came through Sao Paulo's academy before joining Arsenal in a £3.4 million deal in August 2006.
He has made 96 Premier League appearances for the club.