Kumaratunga had argued that a left-over year from her first term should mean she could stay in office until late 2006.
But a five-judge bench headed by Chief Justice Sarath Silva ruled on Friday that her second and final term will end on December 22 this year.
Kumaratunga, who was first elected in 1994, went for reelection a year early in 1999, and her opponents argued that meant she forfeited a year and must relinquish power this year.
"According to the constitution, and the interpretations heard earlier... I hold the President's second term in office commenced on 22 December 1999 and will end six years from that date," Chief Justice Sarath. N. Silva said.
Elections Commissioner Dayananda Dissanayake told Reuters an election would be held this year.
Rajapaksa is likely to seek an
electoral alliance with Marxists
Prime Minister Mahinda Rajapaksa will now go head-to-head with his predecessor and main opposition United National Party leader Ranil Wickremesinghe for the presidency.
"The government machinery has already started working, the election campaign is already on," said Sujeevan Perera, general manager of the European Chamber of Commerce of Sri Lanka.
The election will be the fifth poll since Kumaratunga's reelection in 1999 - general elections were held in 2000, 2001 and 2004 - and analysts say another general election could soon be in the offing.
Billboards on roads from Colombo to the ancient hill capital of Kandy are pasted with party slogans and candidates' pictures.
"These people are crazy. How can we have an election every year like this? How can the economy cope with such a massive expenditure?" said 33-year-old Sunimal Gomes, tending his vegetable stall.
Sri Lanka's financial markets and businesses have voiced widespread frustration with the slow pace of economic reform by Kumaratunga's ruling coalition, which is struggling to govern after its hardline Marxist ally pulled out over plans to share tsunami aid with the Liberation Tigers of Tamil Eelam.
It promises to be a close race, and observers say Rajapaksa will likely need to woo the Marxists back on side to ensure a victory. A 2005 vote would likely take place in November.
Many analysts and traders are hoping for a win by United National Party leader Wickremesinghe, citing his track record in macroeconomic management, foreign investment promotion and advances in a bid to forge lasting peace with the Tigers.
But while political uncertainty is discouraging foreign investment in the $20 billion economy, the Colombo stock exchange is Asia's best performer - up around 40% - as high inflation and low interest rates deter investment in fixed-term assets.
"What we need is a stable government, whichever one it is"
Vivendra Lintotawela, chairman of John Keells Holdings
"What we need is a stable government, whichever one it is," said Vivendra Lintotawela, Chairman of Sri Lanka's biggest conglomerate, John Keells Holdings.
"At the moment it's not stable, so that is delaying most of the reforms that we think needs to be done," he added.