EU Commissioner for Economic and Financial Affairs Pierre Moscovici said the decision reflected "an intelligent application" of the Stability and Growth Pact which sets the fiscal rules member states are supposed to follow.
The move confirms an earlier ruling by the EU Commission.
"By giving more time to Spain and Portugal to bring their public deficits below (the ceiling of) three percent (of GDP), the Council sets new credible fiscal trajectories, which will contribute to strengthening both their economies and the euro area," Moscovici said in a statement.
"Stability and growth require a strong determination to put public finances in order. I trust that Spain and Portugal will respond accordingly," he added.
The European Commission agreed late last month not to impose fines of up to 0.2 percent of Gross Domestic Product for fear of stoking even more anti-European Union sentiment in the wake of Britain's shock vote to quit the bloc.
The final decision rested with the 28 member states in the European Council where many such as France and Italy argued Brussels should cut them more slack as they try to get their economies back on track amid public anger at continued austerity.
Germany in contrast championed the SGP rules as the only way forward, saying that sound public finances are the only foundation for growth.
After six years in recession, Spain reported a 2015 budget deficit of 5.1 percent of GDP, way off the 4.2 percent target set by the Commission.
For this year, the Council said Madrid must find savings equivalent to 0.5 percent of GDP to bring the deficit down to 4.6 percent, and then 3.1 percent in 2017 and 2.2. percent in 2018.
"All windfall gains must be used to accelerate deficit and debt reduction, and Spain must be ready to adopt further measures should budgetary risks materialise," the Council said in a statement.
"Fiscal consolidation measures must secure a lasting improvement of the government's budgetary balance in a manner conducive to economic growth," it said.
Portugal must find savings worth 0.25 percent of GDP to bring its budget deficit to 2.5 percent this year, compared with 4.4 percent in 2015.
The Commission last month warned both countries that should they fail to meet the new targets it would consider suspending their EU structural funds but this would be only at a later date and after discussion with the European Parliament.