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Elliott made his Barclaycard Premiership debut for the Blues at Bolton in February 2004 and is highly rated by the Premiership outfit. He has been a regular goal scorer in the City reserve side netting 11 goals in 15 games, making him leading scorer.
The 20-year old has won international honours with the Republic of Ireland Under-21 team, making his debut against Germany in July 2003.
He claimed a hat-trick in their 5-0 win over Poland and was Ireland's top marksman at the World Youth Championships last November.
Stephen, who expressed his delight at securing his new deal, said: " With my contract about to expire at Manchester City I had various options presented to me but when I heard about Sunderland's interest I was thrilled.
"The prospect of joining Sunderland is very exciting and I am looking forward to having the opportunity to work with Mick McCarthy. Sunderland is a very ambitious club and although I know it's a cliché they are a massive club.
"They deserve to be in the Premier League and hopefully I can play a part in achieving this."
Manager, Mick McCarthy said: "I'm excited about Stephen, he's a great young prospect who has scored goals at every level. I'm delighted he'll be joining us and confident he'll be a great addition to our side."