In only his second first-round loss at a major tournament, the oft-injured 29-year-old fought for four hours, 41 minutes before the inspired Verdasco won 7-6 (8/6), 4-6, 3-6, 7-6 (7/4), 6-2.
It was one of the worst ever Grand Slam performances for Nadal, who also lost in the 2013 Wimbledon first round and has not won a major title since the 2014 French Open.
"It's tough, but at the same time, I know I did everything that I can to be ready for it," Nadal said. "Was not my day. Let's keep going. That's the only thing.
Nadal can at least take heart that the Australian Open has historically been his toughest Grand Slam tournament, with his only win coming against Roger Federer in 2009.
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That year, he fought off Verdasco in another five-set epic which clocked in at five hours, 14 minutes -- the second longest match in tournament history -- in the semi-finals.
But the following year, he limped out of his 2010 quarter-final with Andy Murray during the third set with a knee injury.
Three years later Nadal was hit by a back problem when he lost to Switzerland's Stan Wawrinka in the final and last year he was bounced out by Tomas Berdych in straight sets in the quarters.
On Tuesday, Verdasco looked headed for the exit when he trailed 0-2 early in the fifth set, only to reel off six straight games to snatch only his third victory in 17 encounters with Nadal.
Verdasco, the world number 45, was on fire with his thumping forehand, hitting 41 forehand winners among a total of 90 outright winners.
"I think today's match was kind of like very similar in terms of the (2009) semi, going to a fifth set," Verdasco said.
"Of course at the beginning of the fifth I was thinking about that semi-final. I didn't want to lose and after that break, I started playing really good, hitting very hard serve, forehand, and not making many mistakes.
"So I was very happy with the way that I finished the match."
His reward is a second round clash with Israel's Dudi Sela.