The microstructure and mechanical properties of extruded Mg-2.5Zn-0.5Y alloy before and after annealing treatments were investigated. The as-extruded alloy exhibits a yield tensile strength (YTS) of 305.9 MPa and an ultimate tensile strength (UTS) of 354.8 MPa, whereas the elongation is only 4%. After annealing, the YTS and UTS decrease to 150 MPa and 240 MPa, respectively, and the elongation increases to 28%. Interestingly, the annealed alloy maintains an acceptable stress level even after a much higher ductility is achieved. These excellent mechanical properties stem from the combined effects of fine α-Mg dynamic recrystallization (DRX) grains and a homogeneously distributed icosahedral quasicrystalline phase (I-phase) in the α-Mg DRX grains. In particular, the superior ductility originates from the coherent interface of I-phase and α-Mg and from the formation of the secondary twin {1011}–{1012}(38°<1210>) in the tension twin {1012}.