Delhi were leading 2-1 at the end of the regulation 90 minutes. But with Kerala having won the first leg 1-0, the teams were locked 2-2 on aggregate.
With both teams unable to score over 30 minutes of extra-time, Kerala upstaged the hosts 3-0 in the penalty shoot-out and earned the right to meet Atletico de Kolkata in Sunday's final.
Marcelinho Leite Pereira (21st minute) and Rubén González Rocha (45th+) scored for Delhi while Duckens Nazon got the only goal for Kerala.
In the penalty shoot-out, Josué Currais Prieto, Kervens Belfort and Mohammed Rafique got their attempts on target while done of the Delhi players could hold their nerve.
Delhi were reduced to 10 men when Milan Singh was sent off for a rough challenge on Mehtab Hussain. But the hosts did well to give a tough fight despite the one-man deficit and in fact created more scoring chances than their opponents.
Kolkata and Kerala had met in the final of the inaugural edition in 2014 as well with the former emerging as the champions.
The boys from the south will be raring to win on Sunday and erase the memories of that painful defeat.
Both teams started off on an aggressive note with Kerala catching the rather off-colour Delhi defence on the wrong foot time and again.
At the other end of the pitch, Kerala goalkeeper Sandip Nandy was not in the best of form, committing a host of errors.
The former East Bengal goalkeeper was guilty of some poor coordination as a poor clearance from defender Kadio saw Marcelinho in posession inside the Kerala penalty box and the Brazilian cashed in by handing Delhi the lead.
The Dynamos had the last laugh in the opening 45 minutes after Ruben gave his team the lead again in added time.
A freekick from Marcos Tebar saw Ruben rise high and sneak the goal home even as goalkeeper Sandip Nandy missed the flight and Kadio couldn't head it away.
Delhi were leading in this game but the teams were tied on aggregate which meant both teams needed another goal. That goal did not happen all through the 90 minutes but it were Delhi who clearly enjoyed the upperhand.
Delhi infact can count themselves unlucky as defender Sandesh Jhingan proved to be Kerala's saviour with a timely goal-line clearance.
Kerala, on the other hand, had their chances with Antonio German firing a long ranger wide from a good position and C.K. Vineeth's diving header missing the target.
In the first half of extra time alone, Delhi came close several times to scoring the goal that would have mattered.
Florent Malouda was the man in form and he forced goalkeeper Nandy to make two good saves.
Once, Nandy's save saw the rebound fall for Marcelinho but his attempt sailed just wide of the target.
Another Marcelinho header from close range fell into the waiting hands of the goalkeeper.