The 31-year-old had been battling to recover from the injury in time for the tournament, which takes place in September and October in New Zealand, with Scotland opening their campaign on September 10 against Romania.
Although the Stade Francais player is hopeful of returning to fitness ahead of that date, an early decision has been taken to withdraw him from contention.
Scotland coach Andy Robinson revealed on the Scottish Rugby Union's website: "After talking this through with Hugo, we've taken the decision to stand him down from our Rugby World Cup squad by mutual consent.
"Hugo has been working hard to recover from a knee injury but has not been able to take a full part in our training camp and while he may be fit to resume playing in mid-to-late August, both Hugo and I have decided that he will not be part of our World Cup plans.
"Hugo has been very diligent in his rehabilitation programme and I'm sure he will be determined to perform for Scotland again in the future."
Southwell, who played five games in the 2007 tournament in France, will not be replaced in Scotland's squad, leaving Robinson with 38 players to work with. The coach will announce his final 30-man party on Monday, August 22.
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The entire All Blacks apparel line has been updated for 2013/14. Check out the New Zealand All Blacks polo.
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