On a day where Mercedes showed encouraging pace but also had issues, Hamilton was running seventh - where he finished - but looking likely to jump up the timesheet when he took a trip over the Turn 9 gravel and grass.
He recovered the car, but then ploughed into the gravel again and retired seven minutes from the end of the session.
Mercedes executive director Toto Wolff said a problem with the 'bib' - the front floor of the car - had caused the crash.
"I thought to myself, 'what an idiot'," said Hamilton, "but when I got back they explained to me that the front of the bib underneath the chassis was broken."
"Overall it was a good day, if perhaps not the smoothest," the 28-year-old added, "I'm happy with where we are and to see Nico in third place on the timesheets shows that we're pretty competitive.
"The Red Bull is massively quick as it always is: they've obviously been sand-bagging it the whole time in winter as expected and all of a sudden they've pulled out (that) time."
Hamilton's team-mate Nico Rosberg took third fastest - behind Mark Webber in a Red Bull one-two - before stopping on track in the closing moments with a suspected gearbox failure.
Vettel, who had also led the morning session, was quickest for the majority of the afternoon, leading by a second early on.
Webber nosed ahead briefly during the super-soft runs, before Vettel - beginning his quest for a fourth successive world title - took the top spot with a 1m25.908s lap, 0.264 seconds ahead of the Australian.
The teams all switched to heavy fuel runs soon after. Tyre degradation appeared severe, with lap times on short runs dropping off dramatically after the first flying laps, and the pace on longer stints slowing considerably.
Tyre wear also appeared to be a contributing factor in a late-session spin for Webber, who lost grip on the exit of Turn 13 and slid sideways and backwards down the track.
"Overall it was a good day for us, it was pretty seamless and there was no trouble with the car," the 25-year-old Vettel said. "After all the mileage of testing, it was fun to be out there - this circuit doesn't get easier, it's a good challenge."
Former world champion Kimi Raikkonen and Romain Grosjean grabbed the fourth and fifth best times to confirm some impressive showings for Lotus in pre-season testing.
Twice world champion Fernando Alonso and his team mate Felipe Massa had more competitive first than second sessions for Ferrari, finishing sixth and eighth fastest overall to sandwich the unfortunate Hamilton.
"We already knew we were not the quickest and that was confirmed today," said Spaniard Alonso, runner-up in the championship last year.
"The weather is expected to change completely from tomorrow, with wind, rain and a significant drop in temperature, which could influence Sunday's race."
Hamilton had started brightly on a warm and sunny day at Albert Park and finished fourth quickest in the first session but faced the lonely walk back to the paddock after his crash.
Also in trouble were Jean-Eric Vergne, who spun his Toro Rosso across the asphalt run-off, and Giedo van der Garde, who spun off at Turn 6 and got stuck in the gravel with an hour to go.
German Adrian Sutil made an excellent start on his return to Force India after a year out of the sport by setting the ninth quickest time overall, outperforming not only his team-mate Paul Di Resta but also both McLarens.
Jenson Button, who has won three of the last four Australian Grands Prix, only managed the 11th fastest time - 2.386 seconds off the pace - with his new team-mate, Mexican Sergio Perez, lapped 13th quickest.
"It was one of the most difficult days I can remember," said McLaren team principal Martin Whitmarsh. "We've made a lot of changes to the car for this season and we don't fully understand how to get the best out of it yet."
A third practice session takes place on Saturday before qualifying for Sunday's race.