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Magnusson becomes City's fourth signing of the summer so far, joining forward Lee Tomlin, plus midfielders Gary O'Neil and Josh Brownhill.
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Magnusson joined Juventus' academy in 2011 and has spent the past two years on loan at Italian side Cesena.
Chief operating officer Mark Ashton added: "It's been a real team effort from a number of people at the club to get this deal done and I look forward to welcoming him to Ashton Gate."
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The 23-year-old was part of Euro 2016 quarter-finalists Iceland's squad but did not make an appearance in France.
"At the age of 23 has plenty of time to mature as a player."
"He's very mobile, quick and smooth on the ball. He's 6ft 3in and has a great left foot," head coach Lee Johnson told Bristol City's club website.
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