Mutola ran the first lap in 55.97 and surged to the front of the pack with 300 metres to go.
She continued to stretch her lead on a blistering second lap and finished over four seconds ahead of Kenya's Faith Macharia in 1:59.67.
Her time bettered the 1:56.57 she set in Lausanne this month and was all the more remarkable since Madrid's altitude of 700m is hardly suited to middle distancing running.
There was another best of the year from Israel's Aleksandr Averbukh in the men's pole vault.
His mark of 5.93 improved the 5.92 of Frenchman Roman Mesnil in Rome earlier this month and was way ahead of the 5.78 managed by Olympic champion Nick Hysong of the United States in second place.
Mesnil had to settle for fourth place on Saturday with a vault of 5.73.
The other outstanding performance on the track came from Bershawn Jackson of the United States, who clocked 48.23 seconds to win the 400m hurdles.
Jackson's time was the second fastest in the world this year, behind only the 47.80
Matt Hemingway's leap of 2.30 was enough to give him victory over Russia's Mikhail Tsvetkov in the high jump and inspire a celebratory overhead flip from the American.
In the men's 800 metres, Denmark's Wilson Kipketer was upstaged by Mbulaeni Mulaudzi of South Africa, who won in 1:44.42.
Mulaudzi's compatriot Hezekiel Sepeng was just behind in second spot, with Kipketer trailing in third in 1:45.03.
Namibia's former world champion Frank Fredericks, one of the other crowd favourites racing on a warm night in Madrid, coasted to victory in the men's 200 metres in a time of 20.24 seconds to show that even at 35 he cannot be written off for the world championships.
Brigitte Foster produced an excellent performance in the women's 100m hurdles, the in-form Jamaican winning comfortably in 12.62, well ahead of the American Donica Merriman.
In the women's 200m, Kim Gevaert of Belgium won at a canter in 22.66.
There was plenty for the home crowd to cheer, with Juan Carlos Higuero taking the 1500m in 3:34.54 and world indoor champion Manuel Martinez winning the shot put with a throw of 20.96.
