The unanimous ruling on Friday caps months of political turmoil that have overshadowed efforts to deal with the administration of US President Donald Trump at a time of slowing growth in Asia's fourth-largest economy.
The decision sets in motion a race to elect the next president within 60 days as required by the constitution.
Prime Minister Han Duck-soo will stay on as acting president until a new leader is sworn in.
Lee Jae-myung, the populist leader of the liberal Democratic Party who had lost to Yoon by a razor-thin margin in 2022, is a clear frontrunner but faces legal challenges of his own under multiple trials for corruption.
Acting Chief Justice Moon Hyung-bae said Yoon violated his duty as president with his December 3 martial law declaration, acting beyond his constitutional powers with actions that were "a serious challenge to democracy".
"(Yoon) committed a grave betrayal of the people's trust," Moon said, adding that Yoon's declaration created chaos in all areas of society, the economy and foreign policy.
Thousands of people at a rally calling for Yoon's ouster, including hundreds who had camped out overnight, erupted into wild cheers on hearing the ruling, chanting "We won!"
Supporters of Yoon who were gathered near his official residence watched the ruling on a big screen in stunned silence.
Some reacted in anger, with one protester arrested for smashing a police bus window, the Yonhap news agency reported, while others held their heads in their hands and wept.
In a message released through his lawyers, Yoon apologised to South Koreans, saying "I am so sorry and regretful that I wasn't able to live up to your expectations".
Yoon has been holed up in his official residence since his release from jail on March 8.
The court rejected most of Yoon's argument that he declared martial law to sound the alarm over the main opposition party's abuse of its parliamentary majority, saying there were legal avenues to address disagreements.
Mobilising the military against parliament to disrupt its functions was a grave violation of Yoon's constitutional duty to safeguard the independence of the three branches of government, Moon said.
Kwon Young-se, the interim leader of Yoon's ruling People Power Party, pledged to work to stabilise the country with the acting president, who said he would do all he could to ensure an orderly election.
Shoring up growth and formulating a response to a 25 per cent tariff imposed by the United States on South Korean imports are urgent priorities for the government.
Yoon, 64, still faces a criminal trial on insurrection charges related to the martial law declaration, which carries a maximum sentence of death or life imprisonment.
The embattled leader became the first sitting South Korean president to be arrested on January 15 but was released in March after a court cancelled his arrest warrant.
Oral arguments in the case start on April 14.
The crisis was triggered by Yoon's surprise late-night declaration that martial law was needed in part to root out "anti-state" elements.
Yoon lifted the decree six hours later after parliamentary staffers used barricades and fire extinguishers to ward off special operations soldiers who arrived by helicopter and broke windows as they sought to enter parliament, where MPs voted to reject martial law.
