Dutch ace Verstappen held off the Ferraris of Kimi Raikkonen and Sebastian Vettel over 71 laps of the Red Bull Ring in Spielberg for his fourth career victory at the tender age of 20.
Hamilton, who overtook teammate Valtteri Bottas to take the lead off the start, looked to be controlling the race until Bottas retired on the 14th lap, bring about a Virtual Safety Car.
The Red Bulls and Ferraris took the opportunity to pit and get fresher tires, but inexplicably Hamilton stayed out.
With wearing and blistered tires, Hamilton was forced to pit from the lead and slipped back to fourth place, venting his frustration over race radio.
“I’m not going to be able to pass anyone. We have thrown away the win,” he said.
Mercedes chief strategist James Vowles bravely owned up to the blunder: “This is James, I have thrown away the win today. I’m sorry,” he said.
To complete a dismal afternoon for the Silver Arrows, Hamilton slowed to a stop on lap 64, his first retirement in 33 races.
“We have to work hard to understand what went wrong,” he told Sky Sports.
“Ultimately we were the quickest, we should have won,” he added.
With Vettel finishing third, after starting sixth on the grid, he will go to the British Grand Prix next week with a single point lead in the title race over his arch-rival Hamilton as both bid for a fifth world championship crown.
Ferrari has also taken the lead in the constructors’ championship following the Mercedes meltdown.
For Verstappen, cheered by the mass ranks of the 20,000 Dutch fans on the circuit, it was a continuation of an excellent run of form since a poor start to the season.
“This is amazing for all the Dutch fans here at the Red Bull Ring, this is amazing,” he said after taking the checkered flag.
Teammate Daniel Ricciardo, who had publicly voiced his discontent with Verstappen over qualifying tactics, retired from fourth on the 51st lap with gearbox problems, an unhappy way to mark his 29th birthday.
His misfortune and the travails of Mercedes left Romain Grosjean in the rarified heights of fourth for Haas, with the Frenchman’s teammate Kevin Magnusssen of Denmark in fifth.
Fernando Alonso took an encouraging eighth for McLaren with Sauber prodigy Charles Leclerc in ninth with another impressive drive, further pressing his claims for a seat with Ferrari next season in place of the under pressure Raikkonen.