The Italian sixth seed crashed out on Wednesday as Brit Watson - ranked 58 places below Pennetta - came from a set down to win 6-7 (6-8) 6-4 6-2 in one hour and 56 minutes.
Pennetta looked to be on her way to victory after edging the first-set tie-break, but was broken six times by home hope Watson, who completed a superb comeback to book a spot in the quarter-finals of the grass-court tournament in Eastbourne.
Watson will now face Petra Kvitova in the last eight after the second seed destroyed American Varvara Lepchenko 6-1 6-4.
Meanwhile, eighth seeded Dane Caroline Wozniacki saw off a tough second-round opponent to progress, overcoming Sloane Stephens of the United States 6-3 6-3.
Wozniacki, a winner at Eastbourne in 2009, needed only one hour and six minutes to see off world number 18 Stephens, and was delighted to keep her hopes of regaining the title alive.
"I feel great - it's amazing to be playing out here and Sloane is a tough opponent so I'm really pleased about the way the match went," Wozniacki said.
"I'm through to the next round and hopefully I can get at least one more match out here on the grass."
There was to be some American success, though, with Lauren Davis and Madison Keys set to meet in the next round after both earned surprise victories
Qualifier Davis eliminated Slovakian Daniela Hantuchova 6-3 6-3, while the highly rated Keys racked up 11 aces as she dumped out defending champion Elena Vesnina 7-5 7-6 (11-9).
Camila Giorgi - conqueror of Victoria Azarenka in the first round - beat British wildcard Johanna Konta in three sets to set up a clash with Wozniacki, and Angelique Kerber overcame Alize Cornet 7-5 1-6 7-6 (7-3) in a marathon affair that lasted two hours and 26 minutes.
Kerber takes on Ekaterina Makarova in the quarters after she won the all-Russian clash with Anastasia Pavlyuchenkova 6-3 6-3.