The contract includes an option for further five years beyond 2008 and extends the agreement between Bernie Ecclestone's Formula One Holding and the Hockenheimring GmbH, a state official said.
It will be signed on Sunday in connection with the German Grand Prix, which is celebrating its 75th anniversary.
With Moscow set to host a Formula One race in 2003, the move has appeared to safeguard Hockenheim's place in the Grand Prix calendar.
Formula One chief Bernie Ecclestone has stated that there will be no more than 17 Grand Prix races a year, meaning that a European circuit will have to give way for Moscow's arrival.
A spokesman for the economics ministry in Germany's southwestern state of Baden-Wuerttemberg said the agreement to extend Hockenheim's contract will open the gate for state funds of up to 30 million marks ($13m/14.9m euros) to modernise and expand the facilities. The renovation work will cost a total of 95m marks ($42.4m/48.6m euros).
The 6.8km track will be shortened to 4.5km to make the circuit more attractive for television audiences.
The first German Grand Prix was held in 1926 on the AVUS in Berlin.
The German Grand Prix will be held at the Hockenheimring for another seven years after an agreement to extend the contract was reached between Formula One Holding and the Hockenheimring GmbH.
