In a madcap match, 14th seed Kyrgios looked in command with a two sets lead before a familiar meltdown in the third set changed the complexion of the contest.
The 89th-ranked Seppi, who saved a match point, advanced to a third-round match with Belgium's Steve Darcis with a 1-6, 6-7 (1/7), 6-4, 6-2, 10-8 win in three hours, nine minutes.
Kyrgios was booed off the court by some of the fans, while tennis great John McEnroe hit out at the brash youngster.
"What I don't understand, what I can't accept, is when he stops trying. It's a black eye for the sport," McEnroe said during television match commentary.
Kyrgios said of McEnroe's criticism: "My body was sore. I was hurting. I mean, John McEnroe. Good on him. Great career. Good on him."
Kyrgios was also dismissive of the booing, saying: "Yes, obviously it's not the greatest thing to hear. 10-8 in the fifth, getting booed off, definitely not the best feeling."
While there was mixed feelings over Krygios' stormy exit, Seppi was savoring a memorable victory after losing in five sets to the Australian on the same court at the 2015 Australian Open.
"Maybe it was meant to be. It was a tough match and I didn't start well. I could not get the rhythm but I started to play better," he said.
"Last time I was two sets up and lost and I tried to do the same this time. I kept on fighting and did very well in the important moments at the end." - 'It's on me'.
Kyrgios is making his return from a ban for "lack of best efforts" commonly known as tanking, during a match in Shanghai, and has been seeing a psychologist.
But yet again Kyrgios' brittle temperament snapped during the third set as Seppi came storming back after looking out for the count.
Asked how he collapsed so spectacularly, Kyrgios told reporters: "Poor management, I guess. I think I didn't have the best preparation. It's on me. "I did a couple things in the off-season that I'm probably not going to do next time. My body's not in good enough shape. You live and you learn."
Kyrgios was given a warning for an audible obscenity by chair umpire Carlos Ramos before he bounced his racquet angrily into the court after a break of service.
Ramos docked him a point penalty as Seppi served out for the third set to turn the tide against the volatile Australian.
The 32-year-old Italian maintained his composure and seized the advantage as Kyrgios suddenly switched off.
Instead of regathering his composure, Kyrgios rushed through his service games giving away cheap points.