Spain's Nadal, who won gold in Beijingfour years ago and was to carry his nation's flag at next Friday's opening ceremony, said he had failed to recover from a knee problem.
"I am not in a condition to be able to compete," the 26-year-old said in a statement.
"It is one of the saddest moments of my career." Nadal won a record seventh French Open title in June but crashed out in the second round at Wimbledon in a massive upset against lowly-ranked Czech Lukas Rosol.
Earlier this month he pulled out of a charity match against Novak Djokovic at Real Madrid's Bernabeu stadium saying he was suffering from tendonitis and needed to rest.
He had hoped to return to Wimbledon this month to defend his Olympic title and his withdrawal echoes his plight of 2009 when a similar knee problem meant he had to withdraw from the grasscourt grand slam, a year after winning it for the first time in an epic defeat of Roger Federer.
"I have to think of my colleagues, I cannot be selfish and I have to think of the well-being of Spanish sport, especially Spanish tennis, and let a colleague play who has had a better preparation and is in a state to compete," the world number three added.
"Today is one of the saddest days of my career as it was one of my biggest dreams, and perhaps the most anticipated moment to be the flag bearer at the opening ceremony for the Games in London.
"You can imagine how difficult it has been to take this decision."
The tennis competition at the All England Club begins on July. 28 with Serbia's Djokovic seeded one.
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