Arturo Vidal scored a first-half own goal in Santiago before Victor Caceres and Richard Ortiz struck after the interval for Paraguay, who won in Chile for the first time in 10 years.
Chile dominated possession and looked threatening, but they struggled to create chances as they fell to a second defeat in three qualifiers.
Eduardo Vargas went closest twice in what was a below-par display from Chile, who were left in danger of slipping out of the automatic qualification spots with three matches remaining.
The win was a huge boost for Paraguay, ending their four-match losing run and moving them to within two points of Chile.
Alexis Sanchez was unable to get going for the hosts as Chile lacked the creativity needed to break down the visitors.
Juan Antonio Pizzi started a strong Chile line-up, with Sanchez, Vidal and Claudio Bravo all in the XI.
The hosts began brightly but struggled to create anything of note against Francisco Arce's side, who sat relatively deep.
Mauricio Isla hit the post in the 18th minute for Chile, but he was rightly ruled offside.
It seemed Paraguay's best chances would come via set-pieces, and it proved the case with the opener against the run of play.
A teasing delivery from the right was met by Vidal, his flying header finding the top corner of Bravo's net to give Paraguay a 1-0 lead.
Chile continued to dominate possession, but they rarely tested Antony Silva, the Paraguay goalkeeper forced into a save by a 25-yard Vargas effort four minutes prior to half-time.
Pizzi's side went close again in the 53rd minute, but Vargas saw his volley from inside the area blocked by Oscar Romero.
Paraguay stunningly doubled their lead just two minutes later through Caceres.
A rebound fortuitously fell into the path of Caceres, whose powerful strike beat Bravo despite the shot-stopper almost keeping it out.
Chile thought they had pulled a goal back with 20 minutes remaining, but a tight offside call saw substitute Esteban Paredes' strike ruled out.
Along with their continued threat from set-pieces, the visitors started to look dangerous on the counter-attack, sealing their win on the break in additional time through Ortiz.