Schumacher's seat at Mercedes will be taken by McLaren's Lewis Hamilton in 2013, and with a dearth of other options available to him he has opted to quit the sport at the age of 43.
He said: "I have decided to retire at the end of the season. I still feel I am capable of competing against the best but the time sometimes comes to say goodbye and this time it might be forever."
He added: "I had been thinking about whether I had the necessary motivation to carry on but I do not want to do something I am not 100 per cent committed to. Having made the decision I now feel a release."
Schumacher's first stint in F1, between 1991 and 2006 saw him rewrite the sport's record books, winning seven world titles and 91 races.
He will be best remembered for helping to revive Ferrari's fortunes after joining the Prancing Horse in 1996 as part of the 'Dream Team' along with Ross Brawn, Jean Todt, Rory Byrne and Paolo Martinelli, winning five straight titles between 2000 and 2004.
He retired at the end of 2006, but was convinced to make a comeback with the Mercedes team in 2010 by close friend Brawn.
However, his return to the sport he once ruled has not been a success and he has taken just one podium finish over the last three seasons, that result coming at Valencia earlier this year.
There had been suggestions Schumacher would join Sauber, for whom he raced sportscars in the late 1980s and early 1990s, in 2013, but he has instead opted to stop racing.
Schumacher, his voice breaking with emotion, was flanked by Brawn and Mercedes motorsport boss Norbert Haug as he made his announcement.
And Haug paid a glowing tribute to Schumacher.
He said: "I thank Michael. We have known each other a long time, we started together in Group C racing and he went on to be the most successful driver in Formula One, winning more races and titles than any other driver.
"We were competitors against him (when Schumacher was at Ferrari with Mercedes supplying McLaren with engines) and we had always dreamed of working together and it came after Brawn Mercedes won the World Championship in 2009.
"We did not achieve what we wanted to but Michael has laid some strong foundations and I want to thank him from the bottom of my heart."