The 25-year-old had been given a lifeline with the Brisbane-based side after returning to Australia with a two-year contract, but the 2011 Super Rugby champions released him "effective immediately" on Tuesday.
"James has experienced a difficult time personally since returning to Australia and we've been aware of that for some time," Queensland Rugby Union chief executive Jim Carmichael said in a statement.
"It is disappointing that James was not able to reach his full potential while he was with us but after a great deal of thought, we believe it is in his and the Reds best interests that we exercise our release clause in his contract."
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The Reds said O'Connor is likely to return to Europe to continue his rugby career.
He had alienated himself from Australian rugby circles following a succession of off-field incidents.
He was forced into exile in 2013 in England and then France after a drunken row with police at the airport in Perth, but returned to Australia ahead of the 2015 Super Rugby season in a bid to make the Wallabies World Cup squad.
The prodigious talent who could play across the backline, however, did not settle back into rugby in Australia and was bothered by knee and groin injuries.
A public halftime spat with Reds team mate Adam Thomson handed more fuel to the many critics of his attitude.
He was not considered by Wallabies coach Michael Cheika for his expanded initial 40-man squad and subsequently missed out on selection for the World Cup.
"I came to the Reds with the intention of playing my best football in my home state and looking for a fresh start but I've struggled with some personal matters," O'Connor said.
"The Reds are a wonderful team and organisation and I'm very disappointed I wasn't able to achieve my full potential."
(Reporting by Greg Stutchbury in Wellington; Editing by Amlan Chakraborty)
