Further tests were planned to determine whether the injury is a stress fracture, and Davenport said she could be sidelined the rest of the year.
Her withdrawal means there will be no rematch in the final against second-seeded Venus Williams, who beat Davenport this year to win Wimbledon and U.S. Open titles.
Davenport, seeded No. 1, sprained the outside of her left foot last month and aggravated the injury in a first-round win Wednesday over Paola Suarez. Her withdrawal was announced just before she was to take the court for a second-round match against Rossana De Los Rios.
"To have to pull out of a tournament that's probably the highlight of my career, it's devastating," Davenport said.
She played through the injury at the U.S. Open and said she wasn't concerned about it when she arrived in Sydney.
"I was feeling OK until I started practicing on these courts," she said. "They're stickier and harder on my foot than other surfaces."
Davenport said the foot was sore following her first-round match and worse when she tried to practice Thursday morning (Wednesday EDT).
"It was hard to put any weight on it," she said.
U.S. captain Billie Jean King had talked of Davenport being part of a medals sweep.
"It's a very sad moment she can't defend her gold medal properly," King said.
Davenport is a second-generation Olympian, and her victory in Atlanta four years ago marked a career turning point. She has since won three Grand Slam titles and earned the No. 1 ranking.
"Since Atlanta ended I was looking forward to coming here," she said. "I'm not angry. I'm just disappointed and sad."
Williams' victory left her one round from a quarterfinal showdown against the last player to beat her, Arantxa Sanchez-Vicario. The fifth-seeded Spaniard advanced to the third round by beating Patricia Wartusch of Austria 6-2, 6-4.
Williams lost to Sanchez-Vicario at the French Open, then begn her winning streak.
"A few times she has gotten the best of me, but a few times I've gotten the best of her," Williams said. "So we'll see what happens in that quarterfinal, given that we both get there."
Since her last loss, Williams has won Wimbledon and the U.S. Open. Now she wants her first Olympic medal.
"I'd love that," she said with a grin. "Everyone watches at home, and you see people standing on the podium crying and shaking. That would be a nice feeling. It's pretty rare."
Against Tanasugarn, Williams won playing less than her best. She rarely ventured to the net and had 10 double faults, including three in one game.
"I guess I wasn't trying very hard," she said.
Williams saved her only overhead for match point, slamming a winner to close out the victory in 63 minutes.
In men's action, second-seeded Gustavo Kuerten of Brazil beat Rainer Schuttler of Germany 6-4, 6-4; third-seeded Swede Magnus Norman defeated wildcard Paradorn Srichaphan of Thailand 7-5, 6-2; fifth-seeded Russian Yevgeny Kafelnikov beat Argentine Juan Ignacio Chela 7-6 (4), 6-4; and No. 11 Mark Philippoussis of Australia defeated wildcard Kristian Pless of Denmark 6-4, 6-4.
Only seven of the 16 seeded men survived the opening round. Jeff Tarango is the only remaining American in men's singles.
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