A statement posted to the association's website said the sides formally agreed to part ways and their lawyers would meet to agree on a financial settlement.
It said that in his 22 months in the job, the Spaniard had failed to achieve expected results and China's world ranking had plummeted.
"Camacho no longer has the basis of trust to coach the national team and a change of coaches can no longer be avoided," the association said in its statement.
Work on finding a new head coach and coaching staff would begin immediately.
Comacho left several starters on the bench for the June 15 friendly against Thailand and swiftly lost control of the game despite making a number of substitutions.
The loss was the third within a month following defeats to Uzbekistan and the Netherlands.
China is currently ranked 95th in the world, behind Cuba, Uganda, and the Dominican Republic. The national team has only qualified for one World Cup, in 2002, and suffers from chronic mismanagement, poor player development, and dwindling fan support.
Camacho was appointed in 2011 with expectations of leading the team to the 2014 World Cup in Brazil. His settlement could include severance pay of about 3 million euros.
The former Real Madrid defender and Spanish international is the latest in a string of foreign coaches to be placed at the helm in China, a sign of the country's failure to develop strong coaching talent.
The poor performance of the national football team stands in stark contrast to China's dominant showings at the Olympics, where it topped the gold medal table for the first time in 2008.