Williams made 38 unforced errors as 14th seed Pennetta outplayed the American to clinch her fourth victory in their seven meetings.
"I'm really, really happy," Pennetta said in a courtside interview. "After winning last week in Los Angeles I took a lot of confidence and it showed on the court today."
Pennetta has now won 14 consecutive matches and fully deserved her victory, constantly making Williams play one more shot than she wanted and unleashing a series of stunning passing strokes herself.
The Italian won the tiebreak 7-2 and though Williams saved three break points in the eighth game of the second set, Pennetta forced two match points two games later and clinched victory when her opponent sent a forehand long.
Pennetta next plays seventh seed Vera Zvonareva of Russia or unseeded Daniela Hantuchova of Slovakia.
Later on Thursday, Kim Clijsters continues her comeback after two years away from the tour when she plays sixth seed and French Open champion Svetlana Kuznetsova.
Top seed Dinara Safina meets Peng Shuai of China and number two Serena Williams takes on Austrian Sybille Bammer.
