Chan, the city's former top civil servant and dubbed "Hong Kong's conscience" by her supporters, said she would make way for a younger generation of politicians who share her desire for universal suffrage for the city.
"I will not be seeking re-election," 68-year-old Chan announced at a press conference, ending months of speculation about whether she would seek a new term in the Legislative Council in September elections.
"It's a very difficult decision. I judged that we are at a critical moment in the campaign for full universal suffrage ... I have come to the conclusion that it is best for me to make way for younger candidates," she said.
Chan won a landmark by-election for the often powerless legislature last December, defeating pro-Beijing rival and former security chief Regina Ip, and handing the pro-democracy movement a major boost.
Pro-democracy politicians had hoped she would reengergise their movement, which has suffered a humiliating string of results in recent district elections in the former British colony.
Democrats were also dealt a blow after China decided early this year to delay the introduction of full democracy in the southern Chinese city.
They have been campaigning for universal suffage promised under the Basic Law instituted when Britain handed Hong Kong back to China in 1997.
Only half of 60 members in the Legislative Council are currently directly elected, as the city's chief executives are chosen by a panel of 800 industry representatives, most of them loyal to Beijing.
Chan said while she enjoyed working with pro-democracy lawmakers in the past eight months, she urged them to rethink their strategy and groom new talent.
"There is a need for a new strategy, a new card," she said.
She pledged to play an active role in political campaigning for and the nurture of future democracy leaders, so that they would be ready to take on the challenges in the run-up to a fully democratic election system.
The democracy movement had been pressing for the direct election of the chief executive by 2012.
But the Chinese leadership ruled in January that that would not come before 2017 at the earliest. Hong Kong has been under special administrative status since the handover to China and will revert to full Chinese control in 2047.
Chan also condemned current Chief Executive Donald Tsang's failure to address the concerns of Hong Kong residents, singling out the controversial appointment of highly-paid political aides in June.
"The fiasco highlights the unsustainability of a political appointment system that lacks a popular mandate," she said.
"When the chief executive concentrates powers in his own hands, it's very difficult to satisfy people."
Chan's decision comes less than two months after another veteran pro-democracy campaigner, Martin Lee, announced he too would step down from his seat in the legislature later this year.
