The 21-year-old playmaker spent last season on loan at the Mestalla but was restricted to just 16 appearances due to two serious knee injuries.
However, despite his injury troubles, Valencia was keen to turn his loan agreement into a permanent deal and the Spain Under-21 international has signed a five-year contract after an undisclosed fee was agreed.
Canales told his new club's website: "I am very thankful and excited more than ever to return to the field and give the same effort that Valencia have made for me.
"The club has bet and trusted in me which makes me feel very happy and now I am only thinking about my recuperation and helping the team as much as I can.
"I have also noted the huge affection of the fans in every moment and I wish to show them my best play."
Canales joined Real Madrid from Racing Santander in 2010 but struggled to make an impression in the Spanish capital as he failed to score in any of his 16 appearances.
Real Madrid ambassador