Downing, who had only been offered a one-year deal by the Saddlers, made 183 appearances for the club following his release by West Brom in August 2012.
The 24-year-old centre-back has also previously been out on loan at Hereford United, Shrewsbury Town and Barnet.
"I've always liked Paul as a player," said Dons boss Karl Robinson.
The transfer will officially be completed once Downing's existing Walsall deal expires on Thursday.
Downing was one of three out-of-contract mainstays from last season's beaten League One play-off semi-finalists to leave the club, having turned down their respective offers.
Jason Demetriou signed last week for another League One side Southend, while Romaine Sawyers, remains linked with former Saddlers boss Dean Smith at Championship side Brentford.
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MK Dons have signed defender Paul Downing on a two-year deal after he rejected a new contract offer from League One rivals Walsall.