Substitute Francesco Totti slotted home from the penalty spot in injury-time after Lucas Neill had brought down Fabio Grosso in the box, with Spanish referee Luis Medina Cantalejo awarding the spot-kick.
It turned out the final act of a match which - as the Socceroos have made a habit of in their brave run through the tournament - was packed with incident.
Referee ‘got it wrong’: Hiddink
Australian coach Guus Hiddink said there was no doubt in his mind the referee had got it wrong. "If you see the replay, there was no doubt it was not a penalty," Hiddink said.
"That's bitter to see that in the last second. But overall when the emotion goes down, we can very proud of what this team has achieved in the last four games."
The penalty decision was a particularly cruel blow for Neill, who has been the Socceroos' best player of the tournament and was magnificent again today.
Materazzi sent off
The match turned when the Azzuri was reduced to 10 men when centre-back Marco Materazzi was sent off in the 50th minute for a clumsy challenge on Marco Bresciano.
The sending off left the Socceroos to take control of the match against an Italian side which looked on its last legs.
Italy had the best chances of the opening half, with giant striker Luca Toni causing all manner of problems and having three clear chances to open the scoring.
First he headed just wide after only three minutes, before goalkeeper Mark Schwarzer made a super stop of a goalbound Toni shot in the 23rd minute - one of two important saves in the space of a couple of minutes.
The complexion of the match changed entirely when Materazzi was marched, with the Socceroos looking the more dangerous side, with two clear chances to win the match.
First Scott Chipperfield forced a great save from Gianluigi Buffon in the 59th minute, while Tim Cahill powered a header over the bar inside the final 10 minutes.
But the Italians soaked up all the pressure, then launched one last raid of their own when Grosso beat Bresciano wide on the left, worked into the box, and was brought down by Neill.
The Italians will now play Ukraine in Hamburg on Friday (SAT 0500 AEST), after they beat Switzerland 3-0 in a penalty shoot-out.
Totti answered critics
For Italian playmaker Francesco Totti, who broke his left ankle in February and has struggled to find fitness and form since his return, the goal was a perfect response to answer his critics.
"Now let the critics talk about me. Up till now they have massacred me. I am sure now they won't be happy. I never answered back, as I was waiting to give my response on the pitch," said Totti, who exited Euro 2004 in disgrace after being found guilty of spitting at a Danish opponent in the group stage.
However Totti was phlegmatic about his role in the victory. "It was only a penalty, I didn’t do that much."
Kewell absent
The Socceroos were without star attacker Harry Kewell, who entered the stadium on crutches with what appeared to be an injury to his left leg.
Kewell had not trained in either of the Socceroos' sessions ahead of the match, with the official reason soreness in his suspect groin.
But Captain Mark Viduka confirmed after the game that Kewell, who hobbled off the bus and on to the pitch to sit on the bench, was reportedly ruled out by gout.
Teammate Scott Chipperfield said" "We knew for a couple of days he (Kewell) wasn't going to play. He's in a lot of pain; he can't walk."
Gout is caused by a high content of uric acid in the blood which accumulates as crystal in the joints and causes acute pain.
Viduka said he did not believe Kewell had suffered an attack before.
Socceroos ‘devastated’
Football Australia chief executive John O'Neill said the Socceroos were devastated by their loss.
"We are really gutted. Sport can be very cruel, but today it was excruciatingly cruel," he told the Seven Network.
"The dressing room was incredibly sad, lots of tears." But Australia had proved itself to the world, he said.
"We are the great over achievers. We came here as a lowly ranked team, lucky to make it in the eyes of the world, but the world has taken notice, big time, of what Australia has done.
"There was not a team that we have played who was demonstrably better."
Mr O'Neill said there was still widespread support for Lucas Neill, who was responsible for a last minute penalty kick for Italy.
"We can debate it until the cows come home, but Lucas Neill can hold his head up. He contributed to Australia getting as far as we did."
PM ‘broken-hearted’
Prime Minister John Howard, in Indonesia on an official visit says he was broken-hearted by the Socceroos’ loss.
"It's a very cruel way to lose, right on the knocker like that, but the team just played so bravely the whole match."
Police separate rival fans
Most of the 10,000 soccer fans who had crammed into Federation Square in central Melbourne remained well behaved throughout the match, but the mood turned nasty when Italy scored a last-gasp goal.
Some Socceroos supporters vented their disappointment by throwing glass bottles at the big screen and stage area, narrowly missing security staff and media, while others threw flares.
Minutes after the final whistle, mounted police rode in to Lygon Street to separate rival fans as violence threatened.
A large of group of mainly young men, many wrapped in Australian flags, marched up Lygon St from the city, yelling, "bullshit, bullshit".
But the situation was contained, with police and private security guards on foot forming a line and restoring order after a few isolated scuffles.
Police said the crowd was mainly well behaved with just two arrests during the game for drunkenness.
Italian fans ’delighted’
For most Italian fans the Azzurri's rearguard action for almost the entire second half was no lucky escape.
"I am very happy with the outcome. They (the Italian team) are great," said Melanie Guarnieri in Lygon Street.
Another Italian fan, Daniel Rashou, said he was delighted Italy made it through to the next round, even though they had triumphed in controversial circumstances.
"If Australia had gone into extra time, they probably would have won," he said.
Thousands of Italian fans in Sydney also crowded Norton Street in Sydney's western suburb of Leichhardt, the heart Sydney's Italian community, to watch the game on live screen sites.
But the vast majority of Socceroo supporters were angry at the last gasp loss.
"I just feel robbed. " said disconsolate Socceroo fan Jessica Carbone in Melbourne.
"I feel cheated. Australia had more possession ... Australia played a better game," she said.
Another Socceroo fan, Andrew Barcellona, said he didn't think Italy could be proud of the win.
"It was a sad way for Australia to lose. It was quite unfair," he said.
Australia 'won new friends’
Despite the result, Australia had clearly won new friends in the footballing world, both at home and abroad.
Jessica Berg, 27, from Berlin, was one of many Germans that have adopted Australia as their second team.
She agreed with widespread sentiment that while Australia had come extremely close to making the last eight, Italy had drawn on all its experience and cunning to win.
"I'm absolutely gutted," Ms Berg said. "I thought they were 60 seconds away from the quarter-finals.”
Another German, 35-year-old Nico Gundlach, said he had recently moved from his homeland to Sydney because of his high regard for Australia and its people.
"The only thing I can say is that Australians are the best losers you can think of," he said.
"I think everyone in Germany can appreciate what Australia has done and should go to the airport and cheer them off when they leave.
"They lost in style and that's the biggest thing you can do. Right now, I feel like I'm Australian."
Dimitrios Hatzitoulousis, 30, from Sydney, said the hundreds of fans at the Australian end of the ground remained in their seats for up to half an hour after the full-time whistle.
"Some of us, like myself, were in tears, others were in shock and trying to make sense of it all," he said.
"But we are proud of our team and what they've done here and there's definitely a bright future for the Socceroos and football in Australia."