The 36-year-old had been tipped to leave St Andrew's but manager Alex McLeish has opted to keep him for another year just days after a move for Palermo's Fabrizio Miccoli fell through.
Birmingham had been close to agreeing a £5million fee with the Serie A club until Miccoli announced he wanted to stay in Italy.
But Phillips, who joined the Blues in the summer of 2008 from West Brom and has scored 18 goals in 62 appearances, has now pledged his future to the club, extending a career which has also taken in stints with Watford, Sunderland, Southampton and Aston Villa.
McLeish, who has also signed Serbia striker Nikola Zigic from Valencia for £6million, said of Phillips: "There can be no doubting Kev's goal scoring prowess, which is something he's had throughout his career.
"Some people may ask why we've retained the services of a 36-year-old but let me tell you he's still extremely fit, in fact his Prozone figures are excellent - his Body Fat Index is one of the lowest in the Premier League.
"Of course as any player gets older the legs go a little bit but the reason Kev has still got it is because he plays with his head - he's got an instinct that means that more often than not he's in the right place at the right time. He's a natural born finisher.
"He's also great to have around the dressing room because he's a tremendous character. He's bought into the idea of being an impact player for us if the team is under pressure.
"During the first half of last season he was naturally a bit frustrated with not starting games but I had a good chat with him in January and explained what we were looking to do and that there was no better man than him inside the box.
"I saw an extra spark from him in training after that and I know how much he enjoys being a Blues player so the contract extension is good news all round."
He added: "I'm aware that if Kev comes on and partners Nikola that comparisons will inevitably be made of when he played up front with Niall (Quinn) in those Sunderland glory days.
"That was a long time ago when Kev was in his prime but he has still got a great technique and so that partnership is an option.
"We are looking to continue to develop and strengthen the squad and the infrastructure at the club but it's also a season for me not to take any chances. I'm looking to bring in players that I know - and that's another reason why it's great to still have Kev as part of things."
McLeish has also signed goalkeeper Ben Foster from Manchester United and been strongly linked with Wigan winger Charles N'Zogbia.