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Fenati led the line-up for the seven-time MotoGP world champion's first foray into team management this season, and was initially a frontrunner in the Moto3 title battle.
But the 18-year-old Italian has tumbled down the standings over the past three months, achieving only one podium finish since winning at Mugello in June, and struggling to finish in the top 10 in recent races.
Now fifth in the championship, 44 points behind leader Jack Miller, Fenati will start 11th for Sunday's Misano race.
Rossi indicated earlier in the season that his intention was for Fenati to spend a fourth season in Moto3 next year, and the deal was confirmed during the San Marino Grand Prix weekend.
"The team was created just over a year ago and we still need to improve in many areas, but we have already done well, above all thanks to Romano, who has managed to win three races already," said Rossi.
"We have a disadvantage in the standings, but Romano is not too far from the top, there are still six races to go and it is not over yet.
"We are delighted to continue next year. It is crucial for us because Romano has proven that he can win this year and then next year, if we put everything in place, we can do better.
"And I think that we can continue for many more years. I'm glad to have Romano with us."
Fenati added: "Next year if things improve we can be more competitive from Fridays at grand prix weekends.
"We'll have more experience as a team and we can put some things in place so that we can be faster."
Amid tension over Fenati's performances and the future direction of the squad, VR46 recently parted company with team manager Vito Guareschi, who had previously been Rossi's boss during his time at the Ducati MotoGP squad.
While Fenati will be staying in Moto3, the majority of the other 2014 title contenders are set to move up.
Alex Marquez - brother of MotoGP world champion Marc and currently Miller's closest rival - has already sealed a Moto2 deal with the dominant Marc VDS squad, and his Monlau team-mate Alex Rins is set to follow him into the middle category with Sito Pons's team.
Miller continues to be linked to a leap straight into MotoGP with one of Honda's customer teams.
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