The decision followed two days of talks between Grant, 53, and the club's chief executive Peter Kenyon.
The Israeli coach's position had been subject to intense speculation after Chelsea finished runners-up in the Premier League and Champions League.
Russia coach Guss Hiddink, fellow Dutchman Frank Rijkaard and Manchester City boss Sven-Goran Eriksson are among the early favourites to replace Grant.
Chelsea said in a statement on their website that the search for a new coach would now begin and that the club will make no further comment.
The statement said: "Chelsea Football Club can confirm that Avram Grant has had his contract as manager terminated today. This follows meetings over the last two days.
"Everybody at Chelsea FC would like to thank Avram for his contribution since taking over as manager last September.
"We will now be concentrating all our efforts on identifying a new manager for Chelsea and there will be no further comment until that appointment is made."
The futures of Chelsea assistants Steve Clarke and Henk Ten Cate are unclear and no official word has yet been given on their positions.
Grant, a close friend of Chelsea owner Roman Abramovich, took over on 20 September 2007 after Jose Mourinho was sacked.
Frank Rijkaard, Sven-Goran Eriksson and, most recently, Brian Laudrup and Roberto Mancini have all been linked with a possible move to Chelsea.
Despite losing just two Premier League games while in charge, Grant attracted criticism from fans who claimed his team lacked style.
He was also criticised for losing February's League Cup final against Tottenham.
Grant joined Chelsea last summer from Portsmouth as director of football, a decision which apparently did not please Mourinho.
Mourinho was later dismissed after their 1-1 draw with Rosenborg at Stamford Bridge in their opening Champions League game.
Grant, who had never managed a club in England, was asked to take over and later given a four-year contract.
Both Kenyon and chairman Bruce Buck paved the way for change by insisting that Chelsea's performance this season was simply "not good enough".
Buck said: "We have very high expectations at Chelsea and a couple of second place finishes is just not good enough for us.
"So although we never would have thought in September when Jose Mourinho left that we would be able to make it into a Champions League final as we did - and that is fantastic - Chelsea are here to win trophies.
"So although it was an excellent season, we are still disappointed."
A series of discussions finally resolved Grant's future and it is understood the Israeli said his farewells to the players on Friday - telling them it had been a 'privilege' to manage the team.
couldnt help it 
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