The news comes as yet another blow for the 31-year-old cricketer, who was also overlooked for the final Ashes Test at The Oval against Australia.
Panesar was fined by police last week for urinating on Shoosh nightclub security guards at the beach town of Brighton on the south coast of England after he was thrown out for misbehaviour.
His county club, Sussex, had announced they would investigate the matter and have now confirmed that the left-arm spinner has played his last match for them.
"Sussex County Cricket Club can confirm that Monty Panesar will be allowed to leave the club at the end of the 2013 season.
"The club's investigation into the recent incident, which took place on Monday August 5, has been concluded and both parties have reached agreement. He will become a free agent as of Friday September 27, 2013," it said in a statement on Monday morning.
"Additionally, Sussex has agreed to Monty's request that he be allowed to play on loan for a club in Division Two of the LV County Championship until the end of this season," it added.
According to media reports, Panesar is expected to spend the remainder of the season on loan with his former club Northamptonshire.
Essex have also been touted as a likely destination for the remainder of the current campaign.
"I would like to thank Sussex for the opportunities, experiences and support I have enjoyed at the club since 2010, and my gratitude for the contribution Sussex have made in providing me with a platform to gain selection for England on three successive winter tours," Monty said in a statement.
It had emerged over the weekend that the left-arm spinner has been undergoing a difficult time off the pitch in recent months, largely as a result of a bitter divorce from his wife, pharmacist Gursharan Rattan.
His poor form on the field has been linked to his personal turmoil.
"I have endured a challenging time this year off the field and my frustrations have sometimes got the better of me professionally. I apologise for letting the club, my colleagues and my fans down.
"I believe that if I maintain the bowling progress I have made in recent weeks which enabled me to be selected for the Test squad at Old Trafford, I can fulfill my long-held ambition of becoming the best spin bowler in the world, over time," Monty added.
Sussex chief executive, Zac Toumazi, said: "Clearly this season has been a very difficult time for Monty Panesar. Having reviewed the whole situation, the club has agreed that Monty be released from his contract.
"This will give him every opportunity to put his personal and professional life back on track."
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