The DPP picked up just 27, or 24 per cent, with the remaining seats going to other parties.
Chen Shui-bian, Taiwan's president since 2000, immediately resigned as chairman of the DPP, saying he should take responsibility for the heavy defeat.
Many voters blame the DPP for allowing Taiwan's economy to languish under Chen.
Chen's family members and closest aides have also been involved in a series of scandals over the past year, plunging the party into its worst crisis since it was founded in 1986.
The results come as China chose 13 people of its own to represent Taiwan, over which Beijing claims sovereignty, state media said on Saturday.
The 13 were chosen "via a secret ballot", the official Xinhua news agency said, and will sit in China's largely rubber stamp National People's Congress.
The KMT has promised that closer ties with China will revive Taiwan's economy and open the door to new jobs.
The DPP however says that Taiwan's sovereign identity is vital to its democracy.
Voters were choosing from more than 400 candidates vying for 113 the parliamentary seats that was cut from 225 in the previous legislature.
|The big win is a boost for |
Ma's presidential hopes [AFP]
Many voters have grown disillusioned with the independence-leaning DPP, which came to power in 2000, ending more than half a century of rule by the KMT.
One voter, Wu Hsiao-huu, a retired telecom engineer, said: "I am very disappointed at the DPP which has done poorly in the past eight years. The economy is terrible and people are struggling to make ends meet."
'Enough is enough'
Chin Chen-lin, an 83-year-old Taipei resident, agreed: "Enough is enough. Look at what they did to our country. They had their chances and they did not really care for the people."
The win for the KMT represents a significant boost to Ma Ying-jeou, who will stand as the party's candidate against Frank Hsieh, the DPP's successor to Chen, in the presidential election in March.
On the eve of elections, Ma called on supporters "to oust the party that likes to play tricks".
Taiwan's more than 17 million eligible voters also cast their ballots on Saturday on two referendums, one which asks whether parties should return ill-gotten assets to the government, and the other on whether parliament should investigate suspected wrongdoing by government officials.
Each measure needs votes from half the registered electorate to be valid.