Velasquez headed into the title unification bout as the heavy favourite, but he was matched by Werdum throughout.
With Velasquez tiring in the third round, Werdum drew a laboured take down attempt from the 32-year-old and immediately capitalised on it with a guillotine choke that forced a tap-out from Velasquez at 2:13.
Velasquez told the post-fight news conference that he had no excuses for losing and felt that Werdum was the better fighter.
"I was here two weeks before the fight, maybe that wasn't enough," said Velasquez.
"No excuses, Fabricio was the better guy tonight. He fought with great technique, he was very relaxed, so he was just the better guy tonight," he added.
When questioned on why he lost, Velasquez he kept quiet on the subject and rather credited his opponent as the deserved winner.
"Nothing was wrong. Fabricio was the better guy tonight. That's it," Velasquez said. "I've been in this position before where I lost, and that's how I felt."