The 10-year-old Special Tiara (11-1) finished a head clear of Fox Norton (7-1) with Sir Valentino (33-1) third.
It was jockey Noel Fehily’s second big-race victory of the Festival following Tuesday’s Champion Hurdle success.
Douvan, ridden by Ruby Walsh, jumped poorly and was never in contention, finishing seventh.
A post-race examination by a veterinary officer found Douvan to be lame behind.
Fehily told BBC Radio 5 live: “[Special Tiara] felt great and never missed a beat. I have been second in this race a few times so to win one is brilliant.”
Unbeaten in 13 previous starts for trainer Willie Mullins, Douvan’s defeat was described by BBC horse racing correspondent Cornelius Lysaght as “one of the biggest upsets in Cheltenham Festival history”.
Douvan, who was the subject of a £500,000 bet at odds of 1-5, which would have produced winnings of £100,000, had never looked himself, and afterwards Mullins suggested the seven-year-old may have pulled something during the race.
“We are all a bit gobsmacked I think, he didn’t jump as well as we had hoped with his usual fluency,” Mullins told 5 live. “Usually you find something wrong when that happens.
“He probably pulled something, a muscle, a ligament, hopefully something that will come right straight away.
“Over the first two fences, I thought he would have to be a super horse to win this, you don’t get away with that in the Champion Chase.
“I’m hoping he could be one of the best horses I have ever trained. Today clearly was not his day. That’s the way it is.
“We are all disappointed that this happened, now my main job is to find out what is wrong and how long it will take to fix.”
Cornelius Lysaght, BBC horse racing correspondent
The defeat of Douvan has to rate as among the biggest shocks in Cheltenham Festival history.
It’s not just the odds, but since joining Willie Mullins this horse has been winning with an authoritative flamboyance that meant that practically everyone thought his opponents had the proverbial Everest to climb to beat him.
And Douvan’s defeat continued a challenging time for the normally rampant Ricci-Mullins-Walsh team and their expensively assembled string.
But good for Special Tiara, a real trooper, in the race for the fourth time and just holding on to make the ever-reliable Noel Fehily a double championship-winning jockey this week. And he’s on the favourite in Thursday’s feature race too.
Special Tiara’s trainer Trainer Henry de Bromhead said: “He seemed in great form coming into it, but it was hard to believe we could win with Douvan and everything else – Douvan had looked so good.
“For our lad, he just tries his heart out and no-one deserves it more.”
Fehily, 41, added: “I didn’t think we’d beat Douvan, but I thought I had a great chance of being second. I got over the last and was surprised something hadn’t come to me, but I knew he wasn’t stopping.”
After three wins on the opening day, trainer Gordon Elliott claimed another double when Cause of Causes (4-1) won the Cross Country Chase before the fast-finishing Fayonagh (7-1) took the closing Champion Bumper
Both were ridden by experienced Irish amateur Jamie Codd, who also had a Festival double in 2015, and who was full of praise for Cause of Causes.
“He’s run at four Festivals now, been second once and won three times,” he said. “He’s a great little horse and he’s been marvellous for my career.
“He’s an idle little horse but quick when you need him to be.”
The most dramatic finish of the day saw the 7-2 favourite Might Bite beat his Nicky Henderson-trained stablemate Whisper (9-2) by a nose in the RSA Chase.
Might Bite, ridden by Nico de Boinville, was comfortably ahead but made a mess of the last fence and then started to hang badly to his right.
Whisper and Davy Russell saw an opportunity and got past the struggling Might Bite on the run-in, but de Boinville managed to correct his path with the aid of a loose horse and after the pair went past the post together, Might Bite was announced the winner.
There were also first festival winners for trainers Ben Pauling, after Willoughby House (14-1) beat Neon Wolf in the opening Neptune Investment Management Novices Hurdle, and for Nick Williams after the 33-1 chance Flying Tiger took the Fred Winter Juvenile Handicap Hurdle under champion jockey Richard Johnson.
And on Ladies Day, Jessica Harrington claimed her ninth Festival winner when Supasundae (16-1) took the Coral Cup.
However, there was some sad news from the day’s racing after Consul De Thaix suffered a fatal fall during the Novices Hurdle.
His jockey Mark Walsh was treated for what was described as a “concussive head injury” and has been ruled out for the remainder of the Festival.
After his wins in the Champion Hurdle (Buveur D’Air,) and the Queen Mother Champion Chase (Special Tiara), Unowhatimeanharry could give Noel Fehily a third big-race win in the Stayers’ Hurdle, the feature race on day three.
The nine-year-old is unbeaten in his last eight starts, including in the Albert Bartlett Novices’ Hurdle 12 months ago, and is likely to be sent on his way at very short odds – but he likes very testing ground and the drying conditions may not be to his liking