The Scot won the first set in a clinical tie-break, but a white feather fluttering on to court appeared to upset his rhythm in the second set tie-break, which he lost.
He then needed medical attention for a foot problem, and Djokovic upped his performance to take the next two sets with some astonishing finishes to lengthy rallies.
The Serb broke Murray's service twice in the fourth set, and ran out the winner 6-7, 7-6, 6-3, 6-2 in a near four-hour match.
It was revenge for his loss at the US open last year, when the UK number one beat Djokovic in a five-set classic. He also became the first man to win Australian titles in a row during the open period.
A clearly emotional Murray was gracious in defeat, saying on court: "Firstly obviously, I'd like to congratulate Novak. His record here is incredible.
"I'd also like to thank the whole crowd, there's such a great atmosphere to play in and you're all very fair, so thank you very much."
He added: "I'll see you guys next year. Thank you."
Murray's grand-dad Roy Erskine from Dunblane praised his grandson after his defeat.
He said: "There's always disappointment when you get a result in a big match like that.
"The quality of Djokovic's last two sets was just unbelievable. How well he played after he won the second set to break up his game. His service improved and he wasn't missing. I don't think we were too upset about the end result."
Mr Erskine also paid tribute to the huge support that Murray has received from the public.
He said: "He's done well with his support. The support from the people of Dunblane has been superb. That was shown in his homecoming to Dunblane last year. To see all those people line the street was wonderful."
Other members of the tennis player's family took to Twitter after the final to congratulate the winner.
Judy Murray, his mother, wrote: "Congrats @DjokerNole. Incredible athlete. Perfect gentleman. #ausopen."
Murray's brother Jamie Murray tweeted: "Congrats to @DjokerNole incredible player and achievement! 3 Aussie Opens in a row. Treat yourself."
David Marshall, CEO of Tennis Scotland, said: "We watched another epic match today between the world no.1 and effectively the world no.2 elect and are guaranteed to see a lot more.
"Andy had a great start with winning the first set but against Djokovic it is never easy.
"In the second set Andy had three break points which was a crucial stage of the match and would have put him in a very strong position had he got the break of serve and won the set.
"It is still another Grand Slam final for Andy and everyone at Tennis Scotland is very happy with that achievement."
Fellow Scots sent their commiserations to Murray, with writer Irvine Welsh tweeting: "Hard luck Andy, did us proud again pal."
Sir Chris Hoy tweeted: "Hard luck Andy Murray, still 3 more attempts left this year."
Other sportsmen to tweet their messages of support included footballer Rio Ferdinand, who wrote: "Unlucky @andy_murray. Nole is a machine man."
Australian cricket player Shane Warne wrote: "Congrats to Djokovic on winning the Australian open tennis final. Wanted Andy Murray to win it."
Tom Daley wrote: "Well played @andy_murray , great match! #teamadidas."
First Minister Alex Salmond said: "This was Andy's third grand slam final in a row and I have no doubt he has many more to come. Andy played a great tournament and put in a fantastic effort. With one grand slam and an Olympic title under his belt Andy is already a Scottish sporting legend."
Labour leader Ed Miliband congratulated both players, writing: "Great achievement for Murray to reach the @AustralianOpen Final. Congratulations to Djokovic on his victory."
The bruising battle was received in his home town of Dunblane with disappointment.Eyes dropped to the floor as fans buried their heads in hands as the final shot was played.
Around 40 people had gathered at a bar in the Dunblane Hotel - many had been there from 8am, for what they hoped would be a historic win for the tennis ace.
One of those who had been cheering on Andy from early this morning was Jennifer Morris, 28, from Dunblane. She said: "It was a bit disappointing, to be honest, compared with the game he played two days ago when it was amazing.
"You could tell, though, through that game (the final) he was sweating, he seemed a bit stressed out by it all and then you saw his foot with the blister. Just from the start I didn't think he had it."
Despite the result, Jennifer remained loyal and supportive of the player.
She said: "I'm proud of him, proud he's from Dunblane, proud he's Scottish, proud he's British we'll support him no matter what."
James Thacker, 33, from Eyemouth, said: "Obviously, it's really, really gutting. He started well and it looked like he could do it but as the match went on it just got further and further away from him.
"The injury on his foot which looked gruesome, and he had a couple of moments like the feather on the court, his ball falling out of his pocket; it seemed to distract him."
Until the final moments Tommy Burns, 27, from Dundee had stayed positive.
"I was really confident for Murray," he said.
"In the second set he took a dip but I thought Murray would iron it out and go on to win it in the end. I was gutted for Murray."
At the end of the game the bar drained of people almost immediately and only a few people remained to drown their sorrows.