World No. 3 Murray, who was the highest ranked player remaining in the draw, squandered a match point before going on to lose to Poland's Jerzy Janowicz.
Murray had been expected to lift the trophy in the French capital after Novak Djokovic's defeat and the withdrawals of Roger Federer and Rafael Nadal.
But he somehow contrived to snatch defeat from the jaws of victory after allowing Janowicz, ranked 69 in the world, to emerge triumphant.
The hard-hitting Pole looked to be heading out of the tournament when Murray served for the match in the second set.
But the Olympic and U.S. Open champion fluffed his lines and from serving for the match at 7-5 5-4 and 40-30, he capitulated in dramatic circumstances to lose the second set 7-6.
The Briton was then swept aside 6-2 in the final set and will now head to the end of season finals in London which begins on Monday.
It is the third consecutive tournament where Murray has lost after holding match points.
Murray was beaten by Canada's Milos Raonic in the last four at the Japan Open in Tokyo after holding two chances to win, while he also went down to Djokovic in Shanghai after failing to convert five opportunities.
"I didn't play a particularly good game and missed a couple of shots that I would have hoped to have made," Murray said on the ATP website.
"He probably gained some confidence from that and started playing better. He played a good tie-break, played aggressive.
"I have to make sure I tighten that up next week, if I get that opportunity in the matches. Make sure I don't let it happen at The O2."
Janowicz, who had already beaten Philipp Kohlschreiber and Marin Cilic before defeating Murray, has enjoyed a stellar year and will now hope to make the semifinals when he faces Janko Tipsarevic -- who clinched the eighth and final place for the season-ending championships.
"In the beginning of this year, I had many changes in my life," Janowicz said.
"I changed the racquet. This racquet which I'm using right now is helping me a lot. Even if I have some weak days, this racquet is actually helping me. So this is one change.
"The second one is, I have a new fitness coach this year, and he's helping me a lot. I'm doing a lot of fitness. When I'm at home I'm actually doing more fitness than tennis.
"So there is this other change. My behavior on the court is also a little bit different. I decided not to give up, whatever the situation is. I'm fighting right now for every single ball."
There was also another shock as home favorite Michael Llodra overcame seventh seed Juan Martin Del Potro of Argentina.
Former U.S. Open champion Del Potro, who has already booked his place at next week's end of season finals in London, went down 6-4 6-3 to the 32-year-old left-hander.
Tipsarevic, who played in London last year as an alternate when Murray pulled out with an injury, ensured his second appearance by defeating Juan Monaco 6-3 3-6 6-3.
"The World Tour Finals last year was one of my best experiences ever on the tennis court. "I was always dreaming of playing the World Tour Finals and I'm excited to be back there," the Serbian said.
Elsewhere, the 2005 Paris champion Tomas Berdych overcame big-serving South African Kevin Anderson 1-6 6-3 6-4 to secure his place in the quarterfinals.
Berdych, who will also play in London next week, will now face France's Gilles Simon after his opponent, Japan's Kei Nishikori, withdrew with an injury.
World No. 8 Jo-Wilfried Tsonga guaranteed his place in London after defeating Spain's 11th-ranked Nicolas Almagro 7-6 (7-4) 7-6 (7-3).
"It's really important for me to have qualified," said the Frenchman, who will next face world No. 5 David Ferrer following the Spaniard's three-set win over Stanislas Wawrinka.
"With the big four at the moment, it's not easy to get rewards in tennis, so for me this is one of my rewards. It feels good to be a part of it.
"I have some great memories from last year where I played the final against Roger. It was huge for me, one of the big moments of my career."
Canada's world No. 13 Milos Raonic was dumped out at the third-round stage after going down 6-3 7-6 (7-1) to Djokovic's conqueror, American Sam Querrey -- who will play Llodra in the last eight.