The former world number one was beaten 2-6 6-4 6-4 by 22nd seed Ekaterina Makarova.
Williams found fine form during the opening set, hitting 15 winners and just 10 unforced errors to help herself win 26 of 44 points, including three break points.
She had the chance to go 4-2 up in the second, but failed to convert break point for the first time in the match.
The American remained firmly contention in the set until three consecutive double faults saw her concede a crucial break in game nine.
Williams had made 25 unforced errors in set two, but she regained her composure to race into a 3-0 lead at the start of the decider.
However, Makarova stormed back to secure a gruelling three-set win after 149 minutes on court.