The unanimous ruling caps months of political turmoil that have overshadowed efforts to deal with the new administration of US President Donald Trump at a time of slowing growth in Asia's fourth-largest economy.
A presidential election is now required to take place within 60 days, according to the constitution, with Prime Minister Han Duck-soo to continue serving as acting president until the new president is inaugurated.
Acting Chief Justice Moon Hyung-bae said Yoon violated his duty as president with his December 3 martial law declaration, acting beyond his constitutional powers with actions that were "a serious challenge to democracy".
"(Yoon) committed a grave betrayal of the people's trust who are the sovereign members of the democratic republic," Moon said, adding that Yoon's declaration of martial law created chaos in all areas of society, the economy and foreign policy.
Thousands of people at a rally calling for Yoon's ouster, including hundreds who had camped out overnight, erupted into wild cheers on hearing the ruling, chanting "We won!"
Supporters of Yoon who were gathered near his official residence watched the ruling on a big screen in stunned silence.
Some reacted in anger, with one protester arrested for smashing a police bus window, the Yonhap news agency reported, while others held their heads in hands and wept.
The court rejected most of Yoon's argument that he declared martial law to sound the alarm over the main opposition party's abuse of its parliamentary majority, saying there were legal avenues to address disagreements.
Mobilising the military against parliament to disrupt its functions was a grave violation of Yoon's constitutional duty to safeguard the independence of the three branches of government, Moon said.
One of Yoon's lawyers, Yoon Kab-keun, told reporters the court conducted the trial in questionable manners and the ruling "can only be seen as a political decision".
Yoon has not emerged from his official residence, where he has been holed up since his release from jail on March 8.
Kwon Young-se, the interim leader of Yoon's ruling People Power Party, apologised to the people, saying the party humbly accepted the court's ruling and pledged to work with Acting President Han Duck-soo to stabilise the country.
Han said he would do all he could to ensure an orderly and peaceful presidential election.
Yoon, 64, still faces a criminal trial on insurrection charges related to the martial law declaration, which carries a maximum sentence of death or life imprisonment.
The embattled leader in January became the first sitting South Korean president to be arrested but was released in March after a court cancelled his arrest warrant.
Oral arguments in the case starts on April 14.
The crisis was triggered by Yoon's surprise late-night declaration that martial law was needed to root out "anti-state" elements and to stop the alleged abuse of its parliamentary majority by the opposition Democratic Party.
Yoon lifted the decree six hours later after parliamentary staffers used barricades and fire extinguishers to ward off special operations soldiers who arrived by helicopter and broke windows as they sought to enter parliament, where MPs voted to reject martial law.
Yoon has said he never intended to fully impose emergency military rule and tried to play down the fallout, saying nobody was hurt.
