Williams' withdrawal comes 14 years after her sister Venus pulled out minutes before the semifinal in 2001 -- also with a knee injury -- a move which led to a tournament boycott, amid claims of racism, that only ended this year.
Williams had been due to play Romanian Simona Halep on Friday night, but instead posted news of her withdrawal on Instagram.
"Four months ago I began a journey to play Indian Wells and it was amazing. I never dreamed I could do it. But I would not have been able to do this without my fans. Though it ended early due to injury this year, I have to say I cannot wait to try again next year. Thanks everyone. I love you so much!" Williams posted.
Back in 2001, crowds booed a young Serena as she took on Belgian Kim Clijsters in the final of the competition now known as the BNP Paribas Open. Despite being on home soil, spectators backed Clijsters in scenes former tennis champion and broadcaster Pam Shriver said were difficult to watch.
"You would expect the crowd to be so supportive of the U.S. player, so it clearly was the exact opposite. Because she was American, because she was so young, because she was African-American, predominantly white audience. It was tough, it was tough to listen to," Shriver told CNN's Open Court.
Shriver watched as spectators booed Serena's father Richard and sister Venus, as they walked down the steps to take their seats for the match.
"That's when we realized this crowd is still really upset by what happened in the semifinals," Shriver said.
Minutes before the highly-anticipated semifinal between the two sisters, Venus pulled out due to a knee injury. Her withdrawal seemed to add credence to rumors, which the family denies, that the result of the match had been pre-determined by their father, who kept a tight control on his daughters' careers.
Despite the booing, Williams beat Clijsters to take the title. But the issue did not end there.
Days later, Richard Williams gave a press conference and said the booing amounted to racial abuse, Bill Dwyre, who covered the match for L.A. Times told Open Court. "Richard Williams had said that the n-word had been used and that the booing was racially motivated. ... that was the beginning of Serena never coming back."
'Following her heart'
After 14 years of refusing to play at Indian Wells, Serena Williams, who with her sister has dominated the world rankings for more than a decade, said that she was "following her heart" by deciding to rejoin the tournament.
"In order to forgive you have to be able to really let go of everything," she told reporters at a pre-match news conference. Serena said she discussed it with her father in a "really emotional" conversation and he agreed.
"He said it would be a big mistake if I didn't go back and I thought that was really admirable," Williams said.
Before the match, she told reporters that, by returning, she felt like she'd already won.
"I don't think I need to hold the trophy at the end of it. I feel like I'm already holding the trophy. I've never felt that way before," she said.
"Just being here is a huge win not only for me but for so many people and it's a wonderful feeling."
Williams' early exit gives Halep a free pass to the final.