The 37-year-old Puerto Rican, boxing in his 47th professional contest, was unable to handle the pace set by Brooklyn boxer Ali, who is eight years Cotto's junior.
Both fighters were hurt during the contest but after 12 rounds Ali got the nod from all three judges by scores of 115-113, 115-113 and 116-112.
A six-time world champion in four different weight divisions, Cotto (41-5-KO33) vowed he would stick by his decision to retire.
"It is," he said, when asked if the bout had been his last. "I want to be happy in my home and enjoy my family."
The rapturous welcome he received upon entering the ring was repeated as he departed in defeat.
"Thank you for supporting me at every opportunity," Cotto told his fans. "I'm so glad to call Madison Square Garden my home."
In his 17-year career, Cotto defeated a host of marquee fighters, including Zab Judah, Paulie Malignaggi, Shane Mosley, Antonio Margarito and Ricardo Mayorga.
He was also beaten once by Margarito, while his other defeats came at the hands of American Floyd Mayweather, Filipino legend Manny Pacquiao and Saul 'Canelo' Alvarez.
Ali added: "Good things happen to good people. I have been training since I was eight years old, and I am glad I got this win at MSG, in my hometown.
"I worked hard for it. I took advantage of this fight, and I made sure to make it count. I want to thank Team Cotto, they could have taken an easier fight if they wanted to."
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