Muguruza's 4-6 6-4 6-4 victory marked the ninth consecutive time Kerber has failed to beat a top-20 opponent. She last achieved that feat in 2016 and she has now been beaten by Muguruza in five straight matches.
Romanian Simona Halep could now take the world number one crown if she reaches the semi-finals at Wimbledon. Halep beat Victoria Azarenka on Monday to move into the quarters, where she will face Johanna Konta.
Should Halep fail to advance to the semis, then Czech Karolina Pliskova will take over at number one when next week's rankings are announced.
But there was a bitter irony for Kerber who, despite being somewhat hampered by her left knee, produced her best display in months and yet bids farewell to Wimbledon and her status as the world's best.
"I think we both played a good match but in the end I think it was just two points that decided the match," said Kerber.
"Of course I'm disappointed that I lost the match, because I was really playing good."
Monday's match was always destined to be close, pitting 2016 runner-up Kerber against her 2015 equivalent and there was little to choose between the pair in what was a high quality contest on Court Two.
Kerber broke to go 5-4 up in the first set when at the end of a fierce rally her Spanish opponent went wide and allowed the German to serve out, securing the set with an emphatic smash.
The second set was on-serve until, with Kerber serving at 5-4 down, the tall Muguruza, who had saved three break points in the set, broke to secure it with a fine crosscourt winner.
It was just reward for Muguruza's attacking and positive play and was warmly appreciated by her temporary coach, Conchita Martinez, the Wimbledon champion in 1994.
Kerber's left knee, which she appeared to hurt in the first set, was reducing her push-off on serve with the consequent impact on her speed, but the third set became a battle of nerves and stamina in the early afternoon heat.
The German broke in the first game and led 2-0 but both struggled to hold serve and it was soon 3-3 with two breaks each.
In an epic 10-minute game, Muguruza held for 4-3 with the crowd appreciating some hugely entertaining rallies between the determined pair.
"That definitely was an important game," said the Spaniard.
"I fight. She was fighting. Every point was incredible. I was expecting that though, I was ready to face that situation."
Two games later Kerber dealt with two match-point threats, but Muguruza grabbed the third to book her place in the last eight.
She will next face Russia's Svetlana Kuznetsova after the seventh seed beat Agnieszka Radwanska 6-2 6-4 in the last 16.
(Editing by Mark Heinrich)
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