Martin completed the demanding 45.7km circuit in the Dutch region of Limburg in a time of 58 minutes and 38.76 seconds to better silver medallist Phinney by 5.37 seconds.
Dark horse Vasil Kiryienka of Belarus completed the podium with a surprise ride to take third place, a huge one minute and 44.99 seconds off the winning time set by Martin.
It was a day to forget for pre-race favourite Alberto Contador after the Spanish Vuelta a Espana winner was overtaken by Martin on his way to posting only the ninth best time at Valkenburg.
Martin's win came just days after the 27-year-old German picked up a gold medal as part of Omega Pharma-Quick Step's winning six-man squad in the team time trial.
"There was a lot of pressure on me, the stress was pretty different to handle, everybody was looking at me," the German, who lay on the ground exhausted after crossing the line, said.
"I did not expect it to be so hard - I had to give everything, I was totally dead. The finale was the hardest ever in my career."
For Phinney, it was a second silver medal in four days following BMC's narrow defeat at the hands of Martin's commercial team in the re-branded TTT.
"There were so many turns, so much Dutch road furniture like the roundabouts," the American said. "I could have done some things differently, have gone faster, but I had the best time trial of my life.
"I had a better ride than at the Olympics - that was all I could ask for today."
Phinney finished fourth in both the time trial and road race at London 2012.
Billed as a battle between defending champion Martin and the in-form Contador, the men's elite individual time trial was hampered by heavy showers that engulfed the early starters in a field of 58 riders.
By the time the big favourites rolled down the ramp the roads were drying under the Dutch sun - but the surface was still dangerously slippery. Italian veteran Marco Pinotti, who had set the fifth best time at the second intermediate check, crashed on a tight left-hand bend and was forced to withdraw from the race with a suspected broken collarbone.
Phinney, who had started third last, made it through the offending corner without any trouble - but the 22-year-old came very close to clipping both road furniture and spectators during his blistering ride.
Soon after Pinotti hit the deck, Martin caught and passed Contador to produce one of the images of the day.
Contador fought hard in the second half of the race - and the 29-year-old Spaniard managed to reduce the deficit with an expert ascent of the punchy Cauberg climb close to the finish - but it was too little, too late for Contador, who finished exactly two minutes and 30 seconds down on Martin.
Having been symbolically passed by Martin, Contador was in fact the last rider to complete the lumpy 45.7km route, which featured three categorised climbs and some highly technical sections with narrow roads and tight bends.
Moments earlier, a clearly tiring Martin had just done enough on the Cauberg and along the fast run into the finish to retain his title. Punching the air with his right first, Martin crossed the line 5.37 seconds ahead of his American rival Phinney, who was bidding to become the youngest ever time trial world champion in history.
Phinney's pulsating ride was more than enough to topple Kiryienka from the provisional top-spot after the Belarus veteran had earlier taken the hot seat from Kazakh national time trial champion Dmitriy Gruzdev, who led for most of the afternoon.
Indeed, Gruzdev's times at the three intermediate checks were beaten only by the men who would take gold and silver at the end of the day.
Kiryienka was sure of a bronze medal after Phinney's BMC team-mate and compatriot Tejay van Garderen crossed the line five seconds down on the Belarusian, whose ride was perhaps the biggest surprise of the day - with the exception of Contador's weak performance.
Kiryienka - set to join Team Sky on a three-year contract next season - was only the 28th seed on the day but ended up on the third step of the podium.
Van Garderen finished one place out of the medals in fourth, 1:49.37 down on Martin, while Sweden's Frederik Kessiakoff completed the top five, 1:50.56 in arrears.
In the absence of British time trial specialists Bradley Wiggins and Chris Froome, fellow Sky rider Alex Dowsett was carrying the flag for Great Britain. The 23-year-old finished a respectable eighth place.