Nadal looked sluggish throughout and was thoroughly outplayed by the Russian, who secured his first win of the round-robin phase and can still reach the semis. Nadal, however, will not reach the semis for the first time.
"I didn't arrive at this tournament with the full confidence that you need to win these matches," Nadal said. "And in the moments that I had to play well, I didn't play well. I made mistakes."
Earlier, Robin Soderling became the first player to reach the semis of the season-ending tournament by beating Novak Djokovic 7-6 (5), 6-1. The Swede, who qualified for the eight-player tournament only when Andy Roddick pulled out with an injury, also beat Nadal in straight sets.
The manner of Nadal's defeats was surprising, considering he came to the tour finale feeling refreshed and encouraged, having reached a final and two semifinals.
On Friday he said he was "close to my absolute best," "playing well" and "getting to play against the best players in the world, is perfect for me."
But Davydenko, who won their Shanghai final last month, broke him twice in the first set and was up a break twice in the second. Nadal rallied, breaking back both times to carry momentum into the tiebreak. However, Davydenko kept his cool and clinched it with a forehand winner on his first match point.
"I showed my good tennis," Davydenko said. "Mostly every [time] I play in a tiebreaker the last few months I win."
Davydenko was dictating play seemingly at will in the first set, pushing Nadal from corner to corner with his accurate groundstrokes as the Spaniard grew increasingly frustrated. Nadal slumped his shoulders in despair after double-faulting to go down 0-30 when serving at 1-4, and after losing that game he struggled for the rest of the set. He hardly challenged Davydenko's serve on set point, letting it whizz by for an ace.
When he went down 30-40 on serve in the first game of the second set, it was enough for someone in the crowd to yell "Wake up!"
The Spaniard did, but it wasn't enough.
He held serve and put up a tougher fight for the rest of the set, but Davydenko was simply too good, finishing with 27 winners to Nadal's 12 -- only three of which came in the first set.
"To be out of the [tour finals], well, that's sport and anything can happen," Nadal said. "I tried my best all the time, but it wasn't enough to win these matches."
Davydenko said he was bothered by an aching left leg in the second set but hoped it would not affect him in his last group match against Soderling.
"I'll just see tomorrow, practicing, how I'm feeling," he said.
Soderling outlasted Djokovic in a tense first set despite wasting three straight set points with the third-ranked Serb serving at 4-5. Djokovic then put up little resistance in the second and was broken three straight times, netting a forehand on Soderling's second match point.
"I won two matches in straight sets against the world No. 2 and No. 3. I couldn't have asked for anything more," Soderling said. "So far, I'm enjoying it a lot. But there's still at least two more matches to go. I hope to do really well in those two as well."
The loss ended Djokovic's 11-match winning streak and was his first defeat against Soderling in six encounters.
"I think he's the best player so far in the tournament," Djokovic said. "I didn't enjoy playing today's match, that's for sure. He was serving really well. All credit to him."
Djokovic, who won back-to-back titles in Basel, Switzerland, and Paris before the tournament, beat Davydenko in his first group match and can also still advance to the semifinals. Djokovic plays Nadal in the last group match on Friday, while Davydenko plays Soderling.