The 37-year-old said he would step down with "immediate effect" during a news conference in his home city of Hyderabad, where India host the Kiwis in the opening Test on Thursday.
"It's been 16 years since I made my international debut for India and I feel it's the right time for me to move on," Laxman told reporters in a trembling voice.
Laxman scored 8781 runs in 134 Tests, including 17 hundreds.
His recent form, however, has been poor and clamour had grown in the Indian media to replace India's ageing batting stalwarts following 4-0 series whitewashes in England and Australia.
"I have always kept the country's success and needs ahead of my personal aspirations and I would have loved to contribute to the team's success especially against England and Australia later in the season," Laxman said.
"I think it's the right time to give opportunity to a youngster in home conditions before the tough overseas tours next year."
Former India captain Rahul Dravid was the first of the senior batsmen to retire from the longer format after the team slumped to eight consecutive Test defeats away from home.
Sachin Tendulkar is the last from the golden generation of Indian batsmen to still play for the country.
His decision to let go of the opportunity to hang up his boots in front of his home crowd baffled many, but Laxman said he listened to his inner voice.
"It has been a very tough decision for me. Late until last night I was not able to make up my mind," he said.
"I have always listened to my inner conscience. It was also one reason why I took cricket as a career. I always wanted to become a doctor.
"At the age of 17, my inner voice said that I want to become a cricketer which was definitely a tougher career path. But I listened to that inner voice which I consider a divine voice."
Laxman, who also scored six hundreds in 86 one-day internationals, will be best remembered for his knock of 281 in the second innings against Australia at Kolkata's Eden Gardens in 2001 which helped India beat the tourists after following on.
The victory also stalled the marauding run of Steve Waugh's men, who had won 16 Tests in succession.
The Board of Control for Cricket in India (BBCI) president N. Srinivasan described Laxman as one of his country's best.
"Not many batsmen made batting look as easy as VVS Laxman. He was an exceptional cricketer, who excelled in pressure situations," N. Srinivasan said in a statement.
"If a cricketer's greatness is to be measured in terms of his performances against the best opposition of his time, then Laxman stands right at the top.
"His record against Australia, the world's number one team for the better part of his career, speaks for itself."