Sports minister Hugh Robertson has confirmed the deal with the Hammers and Newham Council has collapsed.
Legal challenges by Tottenham and Leyton Orient, plus an anonymous complaint to the European Commission, have led to fears that court action could drag on for years while the stadium remains empty.
The stadium will now remain in public ownership and leased out to an anchor tenant following a new tender process by the Olympic Park Legacy Company (OPLC).
West Ham vice-chairman Karren Brady has confirmed the club will bid again to become tenants at the stadium.
Robertson said: "The key point is the action we have taken today is about removing the uncertainty. The process had become bogged down in legal paralysis.
"Particularly relevant has been the anonymous complaint to the EC over 'state aid' and the OPLC received a letter from Newham Council yesterday saying because of the uncertainty, they no longer wanted to proceed. That was the straw that broke the camel's back and we thought it better to stop it dead in it tracks now.
"We know there is huge interest in the stadium out there from private operators and football clubs and crucially we remove any uncertainty."
Some £35million already earmarked under the Olympic Budget will be used to transform the stadium after the Games. Prospective tenants will then be asked to bid for the stadium with the running track remaining in place.
Robertson added: "This is not a white elephant stadium where no one wants it, we have had two big clubs fighting tooth and nail to get it.
"The new process will be more like how Manchester City took over the Commonwealth Games stadium which is regarded as a leading example of how to do it."
The tenants would pay an annual rent to the OPLC which should actually prove to be less costly for the likes of West Ham.
The move will also remove uncertainty over the stadium ahead of London's bid for the 2017 world athletics championships, although that was not a major consideration in the decision to abandon the current deal.
The Government, the London Mayor's office and the OPLC have moved to scrap the current deal as there were fears the legal challenges could take years to come to a conclusion.
It is understood that no contract has been signed with West Ham, allowing the move to a fresh tender process, but the club will be encouraged to bid again.
A joint statement by Brady and Kim Bromley-Derry, Newham chief executive, said they welcomed the move.
The statement said: "Uncertainty caused by the anonymous complaint to the European Commission and ongoing legal challenges have put the Olympic legacy at risk and certainly a stadium, as we envisioned it, may not be in place by 2014 due as a direct result of the legal delay.
"Therefore we would welcome a move by OPLC and government to end that uncertainty and allow a football and athletics stadium to be in place by 2014 under a new process. If the speculation is true, West Ham will look to become a tenant of the stadium while Newham will aim to help deliver the legacy."
UK Athletics chairman Ed Warner welcomed the move.
"It's fantastic for UK Athletics and it is a bold and decisive move by the legacy company," Warner told BBC Radio Five Live.
Warner also predicted that the decision would help London's bid for the 2017 World Athletics Championships.
"We had a meeting with the IAAF inspectors last week and we gave Government guarantees that the athletics track will stay in place.
"The move you see today is simply confirmation of what we told the IAAF.
"The IAAF were concerned when they arrived but when they left they told us that the issue was completely resolved. We laid out the legal options and they went away happy.
"I'm very hopeful that we will get the nod for 2017."
London mayor Boris Johnson insisted the stadium would not become a burden to the taxpayer.
He said: "I am confident that this decision is the best way to ensure we have certainty over the stadium's future.
"I believe it will also put us in the place where we always intended to be - delivering a lasting sustainable legacy for the stadium backed up by a robust but flexible business plan that provides a very good return to the taxpayer."
Leyton Orient chairman Barry Hearn welcomed the news and confirmed his club would look to be a tenant when the new tender process opens.
He was keeping his options open regarding the possibility of a groundshare, and believes the OPLC's decision should mean the debate over exactly how the stadium will look in the future is reopened.
"Today is a fabulous day for Leyton Orient fans," he told Sky Sports News.
"It puts the whole thing back in the public domain as it should be. The system of deliverance was fundamentally flawed and now they have got to go back to the beginning and start again and we will be an interested party in that bidding process.
"West Ham are not a shoo-in, that's very good because they will be competing with a host of other people who have claims on and plans for the Olympic Stadium. It's a legacy operation and at last the OPLC have finally listened to someone with common sense and said 'we messed it up before, let's not mess it up again'. The whole process starts now.
"I can tell you that I am definitely interested in being part of the tender process. If that involves groundshare, we will have to look at the situation and see if it makes sense for everyone.
"But we are a small club and we would be lost in a 60,000-seater. Perhaps it makes more sense to go back to the original plan for 25,000 seats which is fine for athletics - perhaps it makes more sense to spend less money on conversion costs and actually get a proper, community-spirited club in there which fits the ethos of what we're talking about, the Olympic Games.
"The expert advice that we got on European law and on state aid showed that the Newham loan was illegal, which we said from day one. No one listened to us at all, they just thought we were little Leyton Orient, just go away and return to the wilderness of the east end of London."