The Chelsea defender paid the price for damaging revelations about his private life and Manchester United's Rio Ferdinand now looks likely to lead England to this year's World Cup.
"After much thought, I have made the decision that it will be best for me to take the captaincy away from John Terry," Capello, known as a disciplinarian, said in a statement.
"As a captain with the team, John Terry has displayed extremely positive behaviour. However, I have to take into account other considerations and what is best for all of the England squad.
"What is best for all of the England team has inspired my choice. John Terry was notified first."
"I fully respect Fabio Capello's decision," Terry said in a statement. "I will continue to give everything for England."
The 29-year-old Terry was given the captain's armband on a full-time basis by former England coach Steve McClaren in 2006 and former AC Milan and Real Madrid coach Capello opted to retain him in the role after he took over in 2008.
In the 15 matches in which he wore the armband under Capello, England won 11 and drew two, qualifying easily for this year's World Cup in South Africa where they will be among the favourites to win the trophy.
"When I chose John Terry as captain, I also selected a vice-captain and also named a third choice. There is no reason to change this decision," Capello said.
"I would like to take this opportunity to thank The FA, particularly Lord David Triesman and Ian Watmore, for allowing me to make this decision in my own time and in the best interest of the team," he said.
England's next game is a friendly against African Nations Cup champions Egypt at Wembley Stadium on March 3.
