The fall in gross domestic product (GDP) between October and December compares with 0.9% growth in the third quarter and will raise fears that the UK is on course for an unprecedented triple-dip recession.
GDP - a broad measure for the total economy - would have to contract again this quarter for the UK to be back in recession, but hopes of a rebound are starting to fade after a snow-hit start to 2013.
The Office for National Statistics (ONS) said economic output as a whole remained flat in 2012.
The fourth-quarter drop is worse than expected, with most economists forecasting a drop of 0.1%.
It deals a blow to recovery hopes after the UK bounced back from the longest double-dip recession since the 1950s in the third quarter.
But the rebound was largely driven by one-off factors, such as the Olympics, and as the economy clawed back activity lost during the Queen's Diamond Jubilee holiday, which has skewed quarter-on-quarter changes in activity, the ONS said.
The fourth-quarter figures are preliminary estimates and subject to revision.
The latest ONS estimate increases the pressure on Chancellor George Osborne at a time when all three major ratings agencies have the country's prized AAA status on negative outlook.
A Treasury spokesman said: "The official forecast was that the UK economy would contract in the last quarter of 2012 so this figure is not unexpected. It confirms what we already knew - that Britain, like many European countries, still faces a very difficult economic situation.
"It underlines what the Chancellor said at the autumn statement and the governor of the Bank of England said this week: while the economy is healing, it is a difficult road."
The ONS said the UK had recovered only half of the fall in GDP seen since the start of the 2008 recession, with output still 3.3% lower than its pre-recession level.
Bank of England governor Sir Mervyn King said earlier this week that the UK had been slower to recover than most other countries.
The biggest drag on GDP came from the production and manufacturing sector, which saw output fall 1.8% quarter-on-quarter, according to the ONS.
Within this sector, mining and quarrying suffered the biggest drop in activity since official records began, down 10.2%, due mainly to the shutdown of the Buzzard oil field in the North Sea amid extended maintenance work.
The powerhouse services sector, which accounts for 77% of the economy, saw activity grind to a halt in the fourth quarter due to the absence of the Olympics boost in the previous three months.
The only bright spot was the construction sector, which delivered a 0.3% rise in output.
But Sir Mervyn insisted earlier this week that there were signs of a "gentle recovery" under way.
Employment continues to remain surprisingly resilient, with figures this week showing that almost 30 million adults were in a job in the quarter to November, up by more than half a million on the previous year.
The Bank and Treasury's Funding for Lending scheme is also starting to help boost credit to under-pressure consumers and businesses.
Mr Osborne today said he would not "run away" from the problems facing the UK economy: "We have a reminder today that Britain faces a very difficult economic situation.
"A reminder that last year was particularly difficult, that we face problems at home because of the debts built up over many years and problems abroad with the eurozone, where we export most of our products, in recession.
"Now, we can either run away from those problems or we can confront them and I am determined to confront them so that we can go on creating jobs for the people of this country."
However, last night Deputy Prime Minister Nick Clegg appeared to admit that the coalition cut capital spending too deeply when it took power.
He said ministers had "comforted" themselves at the time that the reduction was in line with plans drawn up by the previous Chancellor, Labour's Alistair Darling.
Mr Clegg said ministers now realised money for infrastructure was needed to foster recovery and the Government must do more to fuel capital investment if Britain does plunge into a triple dip recession.
In an interview with The House magazine, he said: "If I'm going to be sort of self-critical, there was this reduction in capital spending when we came into the Coalition Government.
"I think we comforted ourselves at the time that it was actually no more than what Alistair Darling spelt out anyway, so in a sense everybody was predicting a significant drop off in capital investment.
"But I think we've all realised that you actually need, in order to foster a recovery, to try and mobilise as much public and private capital into infrastructure as possible.
"Wherever we can we've got to mobilise more capital investment. The economic evidence is overwhelming. It helps create jobs now - people go on to construction sites. It raises the productive capacity of the economy in the longer run.
"Money in people's pockets, people on low and middle incomes, and, and mobilise capital investment will always remain my two - I mean, there are plenty of other things: supply-side reforms, making us more competitive and so on, there's fixing the banks, but those two are the ones I always single out."
Experts believe gross domestic product (GDP) will have fallen by 0.1% in the final quarter of 2012, putting the country on course for an unprecedented triple-dip recession.
Asked if the Government should change tack if that becomes a reality, Mr Clegg said: "What kind of things do I think we need to do where we can? I would single out two things.
"Firstly, we need to try, wherever we can, to put money back in the pockets of people on middle and low incomes, because all the evidence is that it is those people that will tend to spend a bit more money on the high street if they feel they've got a few extra pennies in their pockets."
He added: "And secondly, wherever we can we've got to mobilise more capital investment into productive capital because the economic evidence is overwhelming. It helps create jobs now, people go on to construction sites, it raises the productive capacity of the economy in the longer run."
Labour has repeatedly urged the Government to implement a "plan B" for economic recovery based on temporary tax cuts and to bring forward long-term infrastructure investment.
Rachel Reeves, shadow chief secretary to the Treasury, said: "This is the first admission that this Government has made serious mistakes on the economy. But the real question is what Nick Clegg's Government is going to do about it. We have urged ministers to bring forward infrastructure investment and build thousands more homes, but they have refused to listen.
"Nick Clegg also claims he wants to put money into the pockets of people on middle and low incomes. So he should now admit that the VAT rise was a mistake and cancel the plan to cut tax credits for working families on modest incomes on the day millionaires get a tax cut."