It was the second time in less than a year that Blunkett, 58, the works and pensions secretary, has quit Blair's cabinet, after being forced to resign last December as home secretary in a visa scandal coloured by his love life.
"It became impossible with the frenzy around him to do his job properly," Blair told parliament, adding: "He goes with no stain of impropriety against him whatsoever."
Political analysts said Blunkett's downfall was a blow to Blair, just six months into what the prime minister had hoped would be a triumphant third straight term in power for his Labour Party.
While he was likely to weather the crisis, the main opposition Conservatives were quick to allege that Blair is losing authority in what he has said will be his last term in Downing Street.
"This week marks the final chapter of his administration," said Tory leader Michael Howard. "For how long does the country have to put up with this lame duck prime minister, in office but not in power?"
"For how long does the country have to put up with this lame duck prime minister, in office but not in power?"
Conservative party leader
The sudden development came just a day after Blunkett gave an interview to his hometown newspaper in northern England, the Sheffield Star, declaring that he would not allow his critics to drive him out of office.
Blair's spokesman said: "David Blunkett came to see the prime minister (at Downing Street) this morning.
"The prime minister continued to express his full support for David Blunkett in his position, but David Blunkett said he had reflected on the position and he believed his position to be untenable."
The spokesman said that Blunkett had tendered his resignation which Blair had "reluctantly" accepted.
Rumours that Blunkett had resigned swirled through parliament earlier on Wednesday when he failed to appear before a parliamentary committee as he had been scheduled to do.
He has been at the centre of a furore since it emerged that he failed to get clearance from a watchdog ethics committee to become a director last April of DNA Biosciences, a technology firm in a position to seek government contracts.
He quit his directorship after two weeks when Blair led his Labour Party to a third-term victory in the May general election and brought Blunkett back into the cabinet.
Blair said Blunkett's resignation
leaves "no stain of impropriety"
But it subsequently emerged that Blunkett had links with another company, and with a charity, for which he should have - as a former minister - also sought prior approval.
Under an official ministerial code of conduct, former ministers must consult the Advisory Committee on Business Appointments over any job they take up within two years of leaving office.
The Conservatives, out of power for more than eight years and keen to make political capital out of the uproar, reacted by stepping up their demands for an inquiry into Blunkett's affairs.
Last December, Blunkett was forced to step down as home secretary over allegations that he speeded up the approval of a residency visa for a Filipina nanny employed by his ex-lover Kimberly Quinn, the US-born and married publisher of the conservative Spectator magazine.