The 20-year-old has penned a new deal until 2021.
Manchester-born Grimshaw, a lifelong City fan, was promoted to the first team squad last season and will look to kick on again in the coming season.
Grimshaw made 15 appearances for the EDS and U19s during 2017/18 campaign.
He also made a huge impact for the Under-19s during the run to the UEFA Youth League semi-finals, making crucial saves in the last 16 and the quarter-final penalty shoot-out wins over Inter Milan and Liverpool to see City progress through to the semi-final for the first time.
Grimshaw said: “I’m really happy to commit myself to City for a further three years.
“It’s no secret I’ve been here many years already and that I’ve been a City fan all my life.
“To be at the Club at this exciting time is pretty incredible and to be able to learn and train from goalkeepers like Ederson and Claudio Bravo made this an easy decision for me.”
City’s Director of Football Txiki Begiristain added: “We are delighted Daniel has agreed this new deal.
“His current contract expired at the end of June and we were obviously keen to keep him as part of our squad.
“He is a goalkeeper of great potential and has impressed Pep Guardiola and his coaching staff over the past two seasons with his hard work and progress.
“As a result of this, Daniel will be increasingly involved in the first team set up next season.
“He is young and is still learning his trade, but we are happy he is continuing his education at Manchester City and look forward to watching him progress in the coming seasons.”