"Real Madrid and Malaga have reached an agreement for the transfer of Francisco Roman Alarcon Isco, who will be tied to the club for the next five seasons," said a statement on Madrid's website.
The midfielder, who will reportedly cost around €30 million, is set to be presented on July 3rd at the Santiago Bernabeu after undergoing a medical.
Isco becomes Madrid's first major signing of the close season and the Spanish giants have fought off strong competition from Manchester City to secure the 21-year-old starlet.
City's appointment of Isco's former coach at Malaga, Manuel Pellegrini, as their new manager had appeared to have given the English side the upper hand in negotiations.
However, Madrid's desperation to seal the player's signature increased after his sterling performances at the under-21 European Championships this month, where he guided Spain to a second consecutive title.
"Dribbling skills, imagination and speed are some of the qualities that define this midfielder, who was awarded the Golden Boy prize in 2012 (for the best young player in Europe), is a recent champion of the U-21 European Championships with Spain and at just 21 has already made his debut for the senior Spanish side," Real said.
Isco is also the first signing in Carlo Ancelotti's reign as coach and the Italian hailed the youngster's ability when he was formally presented on Wednesday.
"I can only speak about his quality. He is very good, the Spanish under-21 team has great players and he is the one with the most talent. Isco could play in any team."
A product of Valencia's youth system, Isco moved to Malaga just two years ago for six million euros as the Andalusians invested heavily after being taken over by Qatari Sheikh Abdullah bin Nasser Al-Thani.
It was this season though in which he rose to prominence after the sale of fellow playmaker Santi Cazorla to Arsenal.
The Spaniard shone as Malaga progressed to the Champions League quarter-finals in their first ever appearance in the competition.
Only two late controversial goals from Borussia Dortmund prevented the Andalusians from reaching the last four.
Malaga's on-going financial problems made another transfer at the end of the campaign inevitable, though.
Isco has chosen to continue his career in Spain despite the intense competition for places at the Bernabeu, with the likes of Mesut Ozil, Luka Modric and Kaka all vying for places in the creative midfield roles.