The 31-year-old made a surprise loan move to the Dons from the Premier League club in January and went on to make 18 appearances, the last of which was a goal-scoring one in the play-off defeat to Huddersfield.
After ending last season on a disappointing note at the Galpharm Stadium, the former Leeds and Manchester United player insists he has unfinished business on return to Milton Keynes.
"When I came here last year, I felt part of what the club were trying to achieve," Smith told the club's official website.
"I made it clear I wanted to stay. There were quite a few other clubs in higher divisions that were interested in me but I think for me, in this stage of my career, I've come to the perfect place.
"What I hope for now is two years where I can commit to MK Dons, give everything that I've got and do everything in my power to help us win promotion to the Championship."
Manager Karl Robinson hailed the coup as he secured his number-one transfer target this summer.
He said: "Alan Smith signing gives us great versatility whether it is in midfield or up front, and he is a tremendous character in the dressing room.
"It's a big signing for us. He turned down a number of other clubs to come to MK Dons and I think he will be a great asset for us."
Smith made a name for himself with hometown club Leeds as an 18-year-old, scoring on his debut against Liverpool in 1998. Smith's six-year spell at his beloved Leeds saw him score 56 goals in 228 appearances and he was part of the side that reached the Champions League semi-finals in 2001.
In 2004, following Leeds' relegation from the Premier League, Smith made a controversial switch to Manchester United for a £7million transfer fee. During his three years at Old Trafford Smith won the Premier League title and the Carling Cup, but his time with the Red Devils was marred by a horrific broken leg and dislocated ankle sustained in a FA Cup tie against Liverpool in 2006.
After regaining full fitness Smith made the switch to Newcastle in August 2007 and went on to be a key member of the Magpies' Championship winning side in 2009/10.