A stricken Nadal lost his opening match at the O2 Arena in London, the 16-time grand slam champion upstaged by David Goffin in three sets on Monday.
Initially he showed no obvious ill-effects during a roller-coaster round-robin encounter in front of a supportive crowd but eventually his injury caught up with him and forced him to admit his season is over.
Thiem will play Nadal's replacement, fellow Spaniard and first alternate Pablo Carrena Busta, needing to win to keep his title hopes alive.
Nadal said he would work hard to be ready for the start of the next season.
"I know what I have to do", he said.
With Andy Murray away injured, Roger Federer and Rafael Nadal are the stand-out attractions at this week's tournament but there may be few contests as entertaining as this one, lasting two hours and 19 minutes. Then if the treatment works or not, we will see.
In the decider, Nadal appeared to feel discomfort in his right knee as he went two breaks down but still he refused to admit defeat, recovering a break before eventually succumbing.
Back came Dimitrov, though, with a break to love and he made no mistake in the final game of the match, converting his third match point as Thiem fired long from the baseline.
With Rafael Nadal's withdrawal, there are still many scenarios for the Pete Sampras group players at the ATP Finals in London.
Making his debut at the ATP Finals earlier, Grigor Dimitrov withstood a comeback attempt from Dominic Thiem and held on for a 6-3, 5-7, 7-5 victory.
Thiem grew in confidence as the match progressed into the second set and thanks to a higher percentage of first serves put the pressure on Dimitrov's shoulders, who was broken in the 12th game of the second set to force the decider.
Despite having qualified 13 consecutive times for the ATP Finals and eight appearances, Nadal has never won the event.