Terry faces a trial for alleged racist abuse.
Harry Redknapp is now the odds-on favourite to become the next England manager.
Capello, 65, resigned during a meeting with FA chairman David Bernstein and general secretary Alex Horne at Wembley Stadium.
He was asked to explain why he had committed a serious breach of FA protocol during an explosive Italian television interview on Sunday in which he said he still wanted Terry as England skipper.
During the hour-long talks, it is understood the fiery Italian did not back down and showed no remorse for his comments. FA chairman David Bernstein, however, was furious and had expected Capello to show some contrition before agreeing to issue a joint statement that would have enabled both the FA and the England manager to move forward with a degree of unity.
It is understood Mr Bernstein expected Mr Capello to first inform the FA of any comments he intended to make. Instead, the interview to Italian TV was in the absence of FA media minders.
Mr Bernstein and the FA directors decided to take the captaincy off Terry while he awaits trial and Capello was openly furious.
Asked by the TV interviewer whether he was in agreement with the decision to strip Terry of the captaincy, Capello replied: “No, absolutely not. I spoke with the chairman (David Bernstein) and I told him that I don’t think someone can be punished until it becomes official.”
Bernstein spent Tuesday preparing the ground for the summit, although there will be no going back on the decision to take the armband off Terry, 31.
The FA consider it inappropriate for the Chelsea captain to lead the national team at this summer’s European Championship when his trial does not start until July 9.
But in the FA statement released late last night the chairman praised Capello for his “professional manner” as manager.
Mr Bernstein said: “I would like to stress that during today’s meeting and throughout his time as England Manager, Fabio has conducted himself in an extremely professional manner.
“We have accepted Fabio’s resignation, agreeing this is the right decision. We would like to thank Fabio for his work with the England team and wish him every success in the future.”
Capello’s son Pierfilippo who acts as the football manager’s agent said: “I have spoken with dad and he is fine.
“For the time being we are not going to say anything because that is the agreement we have with the FA, we shall see how things go and then maybe we will speak. It is too early to say what he will do.”
However, Capello launched a blistering attack on the FA and accused them of insulting him.The clearly furious Italian said: “They really insulted me and damaged my authority.
“What really hit me and forced me to take this decision was the fact the much-vaunted Anglo-Saxon sense of justice, as they are the first to claim that everyone is innocent until proven guilty.”
Last night England players and football pundits expressed their surprise at Capello’s dramatic resignation.
Former England player and Everton captain Phil Neville said: “I still believe Capello is a great manager. His record backs that – it just didn’t quite work out with England for many reasons not all his.”
Redknapp is quoted at 8/15 to take the England manager’s job with West Bromwich Albion coach Roy Hodgson next in line.
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