Chief Magistrate Howard Riddle found the 31-year-old Chelsea skipper not guilty at the end of a five-day trial at Westminster Magistrates Court in London.
Terry, wearing a white shirt with a grey suit, left court without speaking to media or supporters waiting outside.
He was accused of branding Queens Park Rangers player Anton Ferdinand a "…" during a match between Chelsea and QPR on October 23 last year.
Terry denied committing a racially aggravated public order offence. He told the court that he was sarcastically repeating words he thought Ferdinand had said to him.
In his verdict, Riddle said that after weighing the evidence it was "highly unlikely" that Terry abused Ferdinand in the manner he was accused of.
"The prosecution evidence as to what was said by Ferdinand at this point is not strong," he said.
"It is therefore possible that what he (Terry) said was not intended as an insult, but rather as a challenge to what he believed had been said to him.
"In those circumstances, there being a doubt, the only verdict the court can record is one of not guilty."
Terry was alleged to have used "threatening, abusive or insulting words or behaviour or disorderly behaviour within the hearing or sight of a person likely to be caused harassment, alarm or distress and the offence was racially aggravated", Riddle said.
"The defendant does not deny that he used the words," he said, but "his case is that his words were not uttered by way of abuse or insult nor were they intended to be abusive or insulting.
"He says they were used after a perceived false accusation made by Ferdinand, the accusation being to the effect that the defendant had used the term... during their exchanges with each other."
Though it was not the issue being judged, Riddle said he had substantial evidence to confirm that Terry was not a racist.
The issue, he said, was whether Terry used the words "by way of insult".
He said there was no dispute that Terry directed the words at Ferdinand.
Terry's reputation had been "at stake" during the trial, Riddle said.
The charge was brought by the Crown Prosecution Service, the state prosecutors in England and Wales.
Alison Saunders, the chief crown prosecutor for London, said in a statement: "The very serious allegation at the heart of this case was one of racial abuse.
"It was our view that this was not 'banter' on the football pitch and that the allegation should be judged by a court.
"The chief magistrate agreed that Terry had a case to answer, but having heard all of the evidence he acquitted Terry of a racially aggravated offence.
"That is justice being done and we respect the chief magistrate's decision."
Had Terry been found guilty, he could have been fined up to £2,500 ($3,850, 3,150 euros).
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