Mr Turnbull emerged victorious in a sudden Liberal leadership ballot, seeing off Mr Dutton in a 48-35 split of Liberal party members.
Mr Dutton has now resigned his powerful position as Home Affairs minister and will move to the backbench, in keeping with the tradition of cabinet solidarity. Mr Dutton was the only challenger for the leadership. Julie Bishop was the only candidate for deputy and was re-elected without opposition.
Prime Minister Malcolm Turnbull called for unity and said he did not bear any "grudge" against Mr Dutton.
"We cannot allow, as I said in the party room today, our internal issues to undermine our work," Mr Turnbull told reporters on Tuesday afternoon. "[It] creates a risk, a real risk, that Bill Shorten will be the prime minister."
Mr Turnbull confirmed he had "invited" Mr Dutton to remain in the cabinet as Home Affairs minister, but Mr Dutton declined.
Treasurer Scott Morrison will step in as acting minister, taking over the crucial portfolio in charge of Immigration, the federal police and Australia's lead intelligence agencies.
The opposition held its caucus meeting on Tuesday but is yet to make public comment on the leadership ballot.
“I don’t know how [Mr Turnbull] can pretend he’s running the country when every backbencher has as much power as he does,” Mr Shorten said.
SBS News understands Labor leader Bill Shorten told colleagues voters were asking "what the hell is going on?"
