McChrystal said in his assessment that Taliban fighters controlled entire sections of the country.
He also criticised the Afghan government for failing the public and said it was riddled with corruption.
"The weakness of state institutions, malign actions of power-brokers, widespread corruption and abuse of power by various officials, and Isaf's own errors, have given Afghans little reason to support their government," McChrystal wrote.
He called for an "urgent need for significant change in our strategy" in Afghanistan, saying the US needs to interact better with the Afghan people and better organise its efforts with Nato.
"Our objective must be the population. The objective is the will of the people, our conventional warfare culture is part of the problem, the Afghans must ultimately defeat the insurgency," he wrote.
The 66-page report, which was confirmed as being genuine by McChrystal's spokesman in Kabul, was sent to Robert Gates, the US defence secretary, in August, and is being reviewed by US President Barack Obama.
"Support for the war is waning, not just among the US public but also among senior Democratic members of congress"
Rob Reynolds, Al Jazeera's correspondent in Washington DC
McChrystal is expected to ask for a troop increase in the coming weeks, with reports he may request up to 30,000 new combat troops and trainers.
But a request for extra soldiers faces resistance from within Obama's Democratic party and some Republicans, while opinion polls also show public support for the war is waning.
"Public opinion in the US has really shifted, and back in the US presidential campaign Afghanistan was a major issue - many Americans I think looked at Afghanistan as 'the good war', in contrast with Iraq," Rob Reynolds, Al Jazeera's correspondent in Washington, said.
"Things have changed now. The US casualties in Afghanistan have risen sharply and there has been a disputed election [in Afghanistan] where there has been clear evidence of fraud.
"Support for the war is waning, not just among the US public but also among senior Democratic members of congress."
A recent CNN/Opinion Research poll showed about 58 per cent of Americans oppose the Afghan war, while 39 per cent support it.
The number of US troops in Afghanistan has almost doubled this year from 32,000 to 62,000 and is expected to grow by another 6,000 by the end of 2009.