Hatoyama sided with residents who have long protested the noise and pollution of the Futenma air base, occupied since the end of World War II.
Supporters wanted the base to stay for the jobs it has created and security.
Last week, shortly following South Korea's claim that North Korea torpedoed one of their ships in neighboring water, Tokyo agreed to allow the base to remain on Okinawa.
The about face by the prime minister sent his approval ratings plummeting in Japan.
The decision is largely in-line with an agreement the U.S. and Japan came to in 2006, under different leaderships for both countries, to move about 8,000 Marines to Guam and the base to a less developed part of Okinawa.
Extra addition newspapers were distributed throughout the capital today following Hatoyama's abrupt announcement.
"The Japanese people are less and less willing to listen to what the Democratic Party (DPJ) says," Hatoyama said as his remarks were broadcast live throughout the country in the morning.
"It is regrettable and I feel responsible," he said.
A successor is expected to be named within days.
Hatoyama listed two reasons for his resignation: "U.S. Futenma air station relocation" and "money and politics." He apologized for employing an aide who violated the political fund control law.
"I never want the DPJ to become implicated in money scandals," he said.
Low approval ratings and the upcoming midterm elections also led to the DPJ leader stepping down.
The last few months of the prime minister's term have been mired in controversy as he fought for Futenma to be moved off the island of Okinawa.
Hatoyama's vow to move the base off Okinawa was a campaign promise he could not deliver and a debate that dominated his term.
"Behind it all was his decline in popular support and the sense that the public had completely lost confidence in him," Gerald Curtis, Columbia University political science professor and author of "The Logic of Japanese Politics," told ABC News. "I think he suddenly realized that there was no way he could save his government."
This is the opposite hope many had for Hatoyama back in September when the Stanford University PhD graduate took office, ending nearly five decades of single-party rule by the Liberal Democratic Party and even landed a spot on TIME Magazine's list of the world's 100 most influential people.
The U.S. Embassy in Tokyo had no comment regarding Hatoyama's resignation, the fourth Japanese prime minister within the last four years to resign.
DPJ Secretary General Ichiro Ozawa, known as the "shadow shogun" also resigned today, reportedly due to Hatoyama's urging.
"That was really the surprise," said Curtis," that he insisted that Ozawa quit along with him, and that's good for Japan."
The DPJ is expected to choose a new leader on Friday, ahead of next month's midterm elections.
"They are going to rush through," Curtis told ABC News, "and probably what's next is public disappointment with the new government and continuing political turmoil in Japan."
According to Japan broadcaster NHK, Deputy Prime Minister Naoto Kan has decided to run for the position.
"They need a leader who can talk to the public, who can inspire the public to think things can get better," said Curtis. "You need a prime minister with real political skill. If you get one, then he can turn things around."