The Wales international was nearing the end of his contract at Selhurst Park and hadn't featured for the Eagles at all during the 2016/17 campaign.
Williams returned to Ipswich on loan for a fourth spell last term, but a shoulder injury limited him to just eight appearances in the Championship.
However, the Palace youth product is hoping to make a contribution for the south Londoners in the future after being handed a new two-year deal.
"I am delighted to be signing this new contract at a club that holds a special place in my heart having been here since I joined the academy at the age of eight," the 23-year-old told the club's official website.
"With the club's fifth season in the Premier League coming up I will be working hard through pre-season so I am ready for the challenge ahead at the start of another campaign."