The 38-year-old made a comment on his Twitter regarding Thomas's appearance in Celebrity Big Brother.
"I wouldn't fancy the bed next to Gareth Thomas #padlockmyarse," Steele tweeted.
"On this occasion Lee's had to pay for his error of judgment. He's made a homophobic comment, [but] that doesn't necessarily mean he's homophobic," said Oxford City manager Mike Ford.
A club statement said: "The Oxford City board have decided to release Lee Steele in view of his recent comment via social media which is considered seriously contrary to the ethos of the club."
Thomas first spoke publicly about his homosexuality in 2009, becoming the first professional rugby player to do so.