Gov. Linda Lingle's administration cited budget shortfalls and other available health care options for eliminating funding for the program.
A state official said families were dropping private coverage so their children would be eligible for the subsidized plan.
"People who were already able to afford health care began to stop paying for it so they could get it for free," said Dr. Kenny Fink, the administrator for Med-QUEST at the Department of Human Services. "I don't believe that was the intent of the program."
State officials said Thursday they will stop giving health coverage to the 2,000 children enrolled by Nov. 1, but private partner Hawaii Medical Service Association will pay to extend their coverage through the end of the year without government support.
"We're very disappointed in the state's decision, and it came as a complete surprise to us," said Jennifer Diesman, a spokeswoman for HMSA, the state's largest health care provider. "We believe the program is working, and given Hawaii's economic uncertainty, we don't think now is the time to cut all funding for this kind of program."
Hawaii lawmakers approved the health plan in 2007 as a way to ensure every child can get basic medical help. The Keiki (child) Care program aimed to cover every child from birth to 18 years old who didn't already have health insurance - mostly immigrants and members of lower-income families.
State health officials argued that most of the children enrolled in the universal child care program previously had private health insurance, indicating that it was helping those who didn't need it.
The U.S. is one of the few western countries that does not have universal health care, although many states have government programs to help parents cover their children.