The Kosovo international spent most of last season as Ederson’s understudy following the injury to Claudio Bravo and will now gain vital experience with the Championship side.
Muric has also penned a new three-year contract extension with City which takes his deal until to 2024.
Last season, Muric was recalled from a loan spell with NAC Breda after just one game to provide cover for Ederson and was handed his debut in the 3-0 Carabao Cup win at Oxford United.
Muric kept another clean sheet in his second game for City – a 2-0 Carabao Cup win over Fulham – but it was his match-winning performance against Leicester in the quarterfinals that showcased the 20-year-old’s potential.
As the game went to a penalty shoot-out, Muric was the hero as he saved spot-kicks from James Maddison and Caglar Soyuncu as he Blues triumphed 3-1.
Muric the featured in both semi-final legs against Burton Albion, keeping two more clean sheets to mean he’d conceded just one goal in his first 420 minutes of senior football.
“Extending my current deal with City by a further three years is incredible and an honour for me,” said Muric.
“I really enjoyed the 2018/19 season and to be involved in our successful Carabao Cup run was an amazing experience.
“The players and supporters have made me feel so happy and part of everything and the Club have showed their belief in me with this deal.
“I want to be the best I can under Pep Guardiola and I’m learning from the very best in the business with Ederson and Claudio Bravo at the Club.
“Going on loan to Nottingham Forest will give me the opportunity to gain more first-team experience and I’m looking forward to the challenge."
Director of Football Txiki Begiristain added: “Aro is a fantastic prospect and has a very bright future at this Club.
“He has already shown his confidence and ability during our Carabao Cup run last season and is only going to get better.
“His attitude, focus and calmness has impressed everyone, and we are delighted he has extended his current deal until 2024.”