The reigning world and European champions have exited the competition at the group stage after being stunned by their South American opponents
After a 5-1 hammering against the Netherlands in their opening Group B clash, Vicente del Bosque's side needed an immediate response, but fell short in another lacklustre showing.
Having fallen behind to Eduardo Vargas' well-taken 20th-minute finish and been pushed to the brink by a second from Charles Aranguiz - helped by another Iker Casillas error - a comeback was never likely.
Del Bosque dropped Barcelona duo Gerard Pique and Xavi following the humiliation against the Dutch, but the change in personnel made little difference as they capitulated once again.
Busquets should probably have put Spain back into the contest early in the second half, but he inexplicably missed the target from close range, and from then on Spain lacked any real invention.
Victory for Chile means that their final group game against the Netherlands will determine who finishes top with both now through to the last 16, while Spain face Australia with nothing left to play for before heading home in despair.
The South Americans looked far brighter in the early exchanges and went close twice inside the first three minutes, as Vargas saw a poked effort deflected agonisingly wide, before Gonzalo Jara headed just off target.
Despite that, Spain gradually appeared to grow into the contest, only to find themselves behind in the 20th minute.
After latching on to Alexis Sanchez's throughball, Aranguiz squared to Vargas, who cleverly side-stepped Casillas before prodding the ball into an empty net.
The world champions almost restored parity eight minutes later, only for Diego Costa to find the side netting after pouncing on David Silva's headed pass.
And Chile soon made the most of their opponents' incompetence again to forge a two-goal lead after 43 minutes.
Aranguiz was at the centre of things once more, but it was Casillas who was the villain yet again. The Real Madrid keeper bizarrely opted to punch a Sanchez free-kick back out into a crowded area when the ball could easily have been caught.
With the defensive wall slow to react, Aranguiz controlled with a deft touch before prodding home past the stranded goalkeeper to put Spain on the brink.
The reigning world and European champions started the second period with renewed determination and they almost pulled a goal back in the 52nd minute, only for Busquets to skew a shot wide from close range after reaching Costa's overhead kick.
Del Bosque's men exerted more control over possession than in the first half, but they still struggled to get Costa into dangerous positions, with the Atletico Madrid forward soon substituted to a chorus of jeers.
Chile should have put the match beyond all doubt in the 68th minute when Mauricio Isla met Eugenio Mena's low cross at the back post, but the Juventus man sliced over, handing Spain a lifeline.
With Fernando Torres on in place of Costa and Santi Cazorla also thrown into the fray, the Spaniards desperately poured men forward in the closing stages and a long-range Andres Iniesta effort forced Claudio Bravo into an acrobatic save.
But it was not enough, as the South Americans held on to their clean sheet and booked their place in the second round.
Spain, meanwhile, were left to reflect on a world title defence that has ended before it even begun - with Del Bosque and his men now assessing just where they go from here.