Dillon first joined the Royals as a player in 1991 and has been rewarded for helping the club to their eighth-place finish last season.
Director of football Nick Hammond said: "Kevin has been an integral part of the football club over the last 16 years.
"I've been with him for most of that time, so I'm delighted he's tied in."
Dillon added: "I'm happy it's been sorted out, but the process has been very quick and there was never a problem."
BBC