Terry, 29, was under intense scrutiny after claims he had an affair with an England team-mate's ex-girlfriend.
The Chelsea centre-half held talks with England boss Fabio Capello at Wembley on Friday to discuss his future.
"After much thought I have made the decision that it will be best for me to take the captaincy away from John Terry," said Capello in a statement.
"As a captain with the team, John Terry has displayed extremely positive behaviour. However, I have to take into account other considerations and what is best for all of the England squad.
"What is best for all of the England team has inspired my choice.
"John Terry was notified first.
"When I chose John Terry as captain, I also selected a vice-captain (Rio Ferdinand) and also named a third choice. There is no reason to change this decision.
"I would like to take this opportunity to thank The FA, particularly Lord David Triesman and Ian Watmore for allowing me to make this decision in my own time and in the best interest of the team."
Capello returned to the United Kingdom on Thursday and is thought to have been keen to resolve the issue before travelling to Poland on Saturday for the Euro 2012 draw.
The Italian, 59, has been recovering from knee surgery at his holiday home in Switzerland and made no comment to the media after arriving back in London.
He has been monitoring the fall-out from the Terry saga closely and has regularly spoken to his trusted lieutenant Franco Baldini.
Baldini, England's general manager, held in-depth talks with four key FA board members on Monday - chairman Lord Triesman, chief executive Ian Watmore, director of communications Adrian Bevington and head of development Trevor Brooking.
They agreed that Capello alone would make the decision about Terry's future and that the priority was to make the right decision rather than a quick one.
Terry, who was appointed captain in August 2008, had issued a brief statement on Wednesday insisting he would be "keeping his own counsel" until he had held talks with the national team coach.
The married father of two is alleged to have had an affair with Vanessa Perroncel, the former girlfriend of England and former Chelsea team-mate Wayne Bridge.
Bridge, who has a son with the French model, moved to Manchester City in January 2009 and is recovering from a knee injury that has kept him out of action for the last two months.
Meanwhile, Perroncel, a lingerie model and former nightclub hostess, said she would not be selling her story.
In a statement read on her behalf by publicist Max Clifford, Perroncel said: "I have decided I do not want to speak publicly about the speculation since it only seems to add more fuel to the fire.
"I have a three-year-old son and he is my main concern. I do not believe speaking to newspapers or the media is in his interest or my own."
