Atletico sacked Abel Resino in October after a poor start to their campaign and Sanchez Flores, a former Real Madrid and Valencia defender who was also capped by Spain, was hired until the end of the season to try to stop the rot.
He led them to a Europa League triumph when they beat English Premier League side Fulham 2-1 in the final in Hamburg, and also a runners-up spot in the King's Cup.
In previous coaching jobs, he guided Getafe to 13th place in their first ever top-flight campaign in the 2004/05 season before taking the helm at Valencia, leading his former club to third and fourth place finishes over the next two terms.
He was sacked three months into the 2007/08 season after a run of poor results and moved to Portuguese club Benfica last season, steering them to third place in the league before stepping down.
Meanwhile 20-year-old midfielder Merida, who has represented Spain at youth level and scored a memorable goal against Liverpool in the League Cup last October, is out of contract with Arsenal at the end of June, Atletico said on their website. He will join on a four-year deal.
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