Filippo Inzaghi struck a hat-trick in 11 minutes in the second half to end Welsh resistance as Mark Hughes' side were ultimately outclassed after a spirited first-half performance.
Wales squandered early chances to spring a shock - but once the deadlock was broken after 58 minutes Wales were torn apart and Italy marched to the top of the group.
And Alessandro del Piero's late penalty only added to the disappointment on a night of misery for Wales.
Hughes' men still have a chance of automatic qualification, but they are now almost certainly aiming to qualify for next summer's showpiece via the play-offs.
And they must regroup against Finland in Cardiff on Wednesday with a seriously depleted side, with Robbie Savage, Craig Bellamy and Mark Delaney all suspended after being booked in the San Siro.
Wales, as expected, were without regular central defensive pair Andy Melville and Danny Gabbidon - but produced trademark resilience in a fierce first 45 minutes.
Indeed Wales had the first opportunity after six minutes, when Ryan Giggs almost took advantage of John Hartson's flick.
And Giggs gave the Italians another scare on the half-hour when he rounded Gianluigi Buffon, but the angle was too tight and he was forced to find Hartson, who shot over.
It was the signal for an incessant spell of Italian pressure which required a combination of brave defending and huge good fortune for Wales to survive until the interval.
Jason Koumas was caught in possession and it needed a magnificent saving tackle from Delaney to save Wales.
Christian Vieiri then set up Inzaghi, who blazed a great chance over the top.
Wales had their biggest escape four minutes before half-time, when goalkeeper Paul Jones turned Del Piero's shot on to the bar before Simone Perrotta struck the rebound against an upright.
The woodwork came to Wales' rescue 10 minutes after the break when Cristiano Zanetti hit the post from 12 yards.
And as Italy hammered on the door, defender Robert Page was forced to acrobatically clear Vieiri's flick off the line.
It was only a matter of time before Italy made the breakthrough, and it finally arrived after 58 minutes.
Del Piero's header was turned on to the bar by Vieri, but this time the Welsh luck was out and Inzaghi was left with a simple tap-in.
And the game was effectively over four minutes later when Inzaghi stole in at the near post to turn substitute Oddo's cross past Jones.
Italy were rampant and Del Piero added a fourth from the penalty spot with 16 minutes left after Simon Davies upended Gianluca Zambrotta.