|Nominal GDP of $5.47 trillion in 2010 put Japan behind China's $5.88 trillion [EPA]
China has become the world's second-biggest economy after the US, pushing Japan to third place in 2010.
Japan lost its 42-year ranking after data released by its cabinet office on Monday showed a contraction in the last quarter due to weak consumer spending and a strong yen.
The data underlined the weak state of a Japanese economy burdened by deflation, soft domestic demand and pressured by the industrialised world's biggest debt.
"It is difficult for the deflation-plagued Japanese economy to achieve self-sustained growth," Naoki Murakami, chief economist at Monex Securities, said.
However, China's leap forward not only reflects a shift in economic power but also highlights the need for shrinking Japan to energise its economy, analysts said.
Stagnation after the Japanese property bubble burst in the 1990s helped put booming China on course to supplant its neighbour.
However, Japan remains around 10 times richer on a per-capita basis, according to the International Monetary Fund.
Predictions vary as to when China may overtake the United States as number one economy, but it should happen by 2025, according to estimates by the World Bank, Goldman Sachs and others.
Duncan Innes-Ker, a Beijing-based analyst at the Economic Intelligence Unit, told Al Jazeera that "China is already at the forefront of the global economy as the largest trader of goods internationally".
The switch in global ranking underscores the nations' stark contrasts: China is growing rapidly and driving the global economy, while Japan is struggling with persistent deflation, an ageing population and ballooning public debt.
Japan's real gross domestic product slipped by an annualised 1.1 per cent in the fourth quarter of 2010 as the expiration of auto subsidies hit car sales, a new tobacco tax sapped cigarette demand and a strong yen hurt exports.
Exports slipped in the quarter as the yen surged to 15-year highs against the dollar, making Japanese goods more expensive overseas and eroding repatriated profits.
The economy grew 3.9 per cent in 2010, its first annual growth in three years. But this was not enough to keep it ahead of surging China.
Nominal GDP of $5.47 trillion in 2010 put Japan behind China's $5.88 trillion, the data showed.
Despite Japan crawling out of a severe year-long recession in 2009, its recovery remains fragile with deflation, high public debt and weak domestic demand.
All this has put more pressure on Naoto Kan, Japan's prime minister, who has seen his approval ratings tumble.
His government is looking to boost the economy without deepening the debt amid a legislative impasse over his $1.1 trillion budget for the next fiscal year.
At present, nearly a third of government spending is being swallowed up by a social security system catering to a rapidly greying society, Standard & Poor's warned, with that ratio set to rise without reforms as Japan continues to age.
Kan's centre-left government has prioritised social security reform and a tax system overhaul, but the opposition has so far refused to begin talks on the issue.
However, the road ahead looks brighter, with economists saying that GDP will expand this quarter in tandem with global growth.
Masaaki Shirakawa, the head of Japan's central bank, said last week that recent signs indicate Japan is emerging from the "pause" and performing at par with other advanced economies.
Ryutaro Kono, chief economist at BNP Paribas in Tokyo, says exports and production have escaped their "soft patches".
"The economy seems to be recovering again from December, so the negative growth in (the fourth quarter) need not become the basis for pessimism about Japan's cyclical outlook,'' he said in a report this month.
The government said Japan's economy would be helped by recovery elsewhere and could reap the benefits of its huge neighbour China, the world's number-one export market.
"We welcome, as a neighbouring nation, that China's economy is advancing rapidly," Kaoru Yosano, the minister for fiscal policy, said.