Many Indigenous Australians criticised the project online, especially over its use of First Nations blood by a non-Indigenous artist.
Dark Mofo creative director Leigh Carmichael released a statement on Tuesday afternoon confirming the project would be shelved.
"We made a mistake, and take full responsibility. The project will be cancelled. We apologise to all First Nations people for any hurt that has been caused. We are sorry."
The festival initially doubled down on the project on Monday, with Mr Carmichael saying that "self-expression is a fundamental human right".
In a letter posted by Dark Mofo prior to the cancellation, Sierra said the artwork was an "acknowledgement of the pain and destruction colonialism has caused First Nations peoples, devastating entire cultures and civilisations".
But not all Indigenous Australians were on board with the project, with some calling it "re-traumatising" and "white guilt art".
"A coloniser artist intending to produce art with the actual blood of colonised people is abusive, colonising and re-traumatising. The idea is disgusting and terrible and should not have been considered,” Noongar writer Claire Coleman tweeted.
Trawlwoolway pakana man Jamie Graham-Blair said Indigenous artists should have been given the money and platform to talk about the impact of colonisation instead.
"Indigenous bodies are not tools to be used by colonisers," he said in an Instagram story. "We are not props for your white guilt art."