The new deal will keep the 27-year-old Irishman at St Andrews until the summer of 2013.
Fahey joined Birmingham from League of Ireland side St Patrick's Athletic in January 2009 and has gone on to establish himself in Alex McLeish's first-team squad, scoring four times in 59 appearances.
"Keith has proved to me that he's a Premier League player," McLeish told the club's official website.
"Having had trials that didn't work out perhaps the way he would have wanted to at clubs when he was younger, he is a brilliant example to young players in that if at first you don't succeed you should try and try again. He got a second chance and he has grabbed it. His is an inspirational story."
Fahey's first foray into English football began with a unsuccessful spell as a trainee at Arsenal before an ill-fated switch to Aston Villa in 2000 that brought just one first-team outing. He subsequently returned to the Irish league before Birmingham offered him a second opportunity to make his mark in England.
"Keith is a brilliant lad who is well-liked and is a great professional," McLeish added. "All of those qualities make him a manager's dream but it shouldn't be forgotten that he's a very good footballer too."
Dublin-born Fahey's impressive form in the Premier League led to him being handed his first senior cap for the Republic of Ireland in a friendly win against Paraguay at the end of May.