City confirmed the fee to be £27 million plus add-ons, while Burnley claim the total package could reach £31 million.
The transfer surpasses the £30 million Everton paid to Sunderland for Jordan Pickford in 2017.
Trafford, a graduate of City's academy, returns to the Etihad just two years after leaving for Burnley in a deal worth up to £19 million. Despite interest from Newcastle, Trafford opted for a move back to Manchester, with City exercising a buy-back clause to secure his return.
The England U21 international has signed a five-year contract and will wear the No. 1 shirt for City.
"Rejoining City is such a special and proud moment both for me and my family," said Trafford in a statement.
"I always dreamed that one day I would be able to come back to Manchester City.
"This is the place I call home - it's a truly special football club.
"I am still very young and hungry to keep learning and improving - and I know there is no better environment than Manchester City to help make me become the best goalkeeper I can be."