Team officials, including owner Eugene Melnyk, announced the deal Wednesday, saying the contract was valid through the 2010-11 season.
Clouston took over the Senators from Craig Hartsburg, who was fired when the team was 17-24-7 this season. Ottawa is 19-10-3 under Clouston but has been eliminated from playoff consideration.
The Ottawa position was the first NHL head coaching job for Clouston, 39, who was behind the bench of Ottawa's American Hockey League affiliate in Binghamton prior to being called to Ottawa.
He was 59-48-12 in parts of two seasons at Binghamton. He was the coach of the Western Hockey League's Kootenay Ice for five seasons, piling up a franchise record 209 wins.