The Rebels, who have struggled since joining the southern hemisphere competition in 2011 and are out of the running for this season's playoffs starting this month, would not offer the 23-year-old a contract beyond 2013, the team said in a statement on Sunday.
"After three years in the Super 15 competition, the club is entering the next phase of development," Rebels Chief Executive Rob Clarke said.
"I am very confident in our player recruitment strategies which continue to identify some excellent emerging talent."
O'Connor's release caps a difficult month for the versatile utility, who was controversially picked at flyhalf by Australia coach Robbie Deans ahead of the Lions series despite having minimal experience in the position at Test level.
Although showing flashes of brilliance, and scoring a fine try in the Wallabies' 41-16 defeat in the deciding third Test in Sydney on Saturday, O'Connor largely struggled in the playmaking position throughout the three-Test series.
O'Connor's off-field record has also been a concern for Australian rugby officials.
The Wallabies back generated headlines last week and irked his senior team mates by being photographed at a fast food outlet with team mate Kurtley Beale at nearly 4 a.m. in the leadup to the second test against the Lions.
O'Connor's public response in the wake of the controversy, snapping at reporters who questioned his discipline, sparked further criticism.
Along with team mate Beale, O'Connor's recruitment after the Rebels' foundation season in 2011, was considered a major coup for the franchise, which has struggled for relevance in a city dominated by rival football code Australian Rules.
But he spent long stints on the sidelines with a succession of injuries and the Rebels continued to struggle even with him on the field.
Attention will now surely turn to Beale's position at the Rebels, whose new senior management have already started a major clean-out of the playing roster and coaching staff ahead of the final round of the season this weekend.
Beale was stood down by the Rebels for over a month after punching his captain Gareth Delve and another team mate in a boozy incident on a team bus in South Africa early in the season. He was stood down again in May for drinking and spent time in a private health clinic.
The Rebels will also part ways with former Wales back-rower Delve and hooker Ged Robinson, along with retiring prop Nic Henderson and number eight Tim Davidson at the end of the season, the team said.