The Danish star needed to reach at least the semi-finals in Melbourne - which is where she progressed last year - to have a chance of retaining her top spot.
But the 6-3 7-6 (7-4) loss to defending champion Kim Clijsters means the No1 spot will now be fought out between the three players ranked just below her - No2 Petra Kvitova, No3 Victoria Azrenka and No4 Maria Sharapova.
Azarenka earlier today moved through to her second semi-final at a grand slam with a three-set win over over Polish eighth seed Agnnieszka Radwanska 6-7 (0-7) 6-0 6-1.
“I'm so happy to get through and especially since I don't have to play a third set. It's so hot out here,” Clijsters told a packed stadium.
“I had to work really hard today. She's a great fighter and plays so well at every tournament.”
Clijsters took time to thank her physio Sam Verslegers, who she said had “magic hands” as he had worked tirelessly on her left ankle for the past 48 hours after she rolled it in Sunday's fourth round win over Li Na.
It was Verslegers who jumped into the arms of Clijsters' coach Carl Maes after the Belgian 11th seed hit the winner into the open court against Wozniacki today.
Clijsters now meets Azarenka for a place in Saturday night's women's final.
Azarenka had a stomach upset, was whitewashed in the first set tiebreak but still managed to overcome anything thrown at her by Poland's eighth seed Agnieszka Radwanska.
The 22-year-old from Minsk showed her mental strength to win the two hour match in baking conditions on centre court that had no correlation whatsoever to Belarus or Poland.
“I don't think I've ever lost a tiebreak to love before. But we two don't seem to be able to play for two sets. We always have to push each other to the limit and keep running around,” Azarenka said.
It was the 10th meeting between the pair and six of those have gone to three sets. Azarenka now leads their head-to-head 7-3.
She is into her second grand slam semi-final after reaching last year's Wimbledon semis, where she lost to eventual champion Petra Kvitova.
During the warm-up, Azarenka doubled over with everyone in her supporters' box showing signs of concern.
“I was just feeling a little sick in the stomach but I'm Okay, I'm fine,” she said in her post-match interview.
Three sets of tennis in scorching heat wouldn't have been ideal but the world No.3 said she was heading straight to an ice bath and some physio.
She also said she didn't find the crowd mimmicking her `screech' when she hits each shot a distraction.
“I don't feel the crowd distracts me because I love you guys. Thankyou for coming out in the heat to support us.”
Channel Seven commentator Rennae Stubbs pointed out that in the past Azarenka had not been able to control her on-court emotions and that sort of jostling from the crowd would have upset her.
“You know I think I'm a year older and a year wiser so it doesn't get to me.”