The Australian Rugby Union has announced the decisions following an investigation into the wayward Wallaby's behaviour at Perth airport last month that led to him being refused entry to a flight to Bali.
The parties say they came to a mutual decision that O'Connor would be granted an early release from his national contract for the remainder of this year.
Provided O'Connor plays for an Australian Super Rugby team in 2014, he will still be considered for the Wallabies but will only receive match payments, with no top-up from the ARU in his contract.
It's a massive financial blow for the 23-year-old.
O'Connor was axed from Australia's Rugby Championship squad, missing the final two games against South Africa and Argentina, who they play in Rosario on Saturday.
The Australian Rugby Union said O'Connor needed to make significant changes to his behaviour.
"We have determined that James must make some changes with respect to his off-field responsibilities and ensure that this approach is consistent with the values of our game," said ARU chief executive Bill Pulver.
"We are hopeful that James will stay in Australian rugby and play in next year's Super Rugby competition and that he sees this as an opportunity to re-focus his attitude."
Dependent on his behaviour O'Connor, who has played 44 Tests, could be considered for a national contract in 2015.
O'Connor, who was cut from the Melbourne Rebels and is in talks over a Super Rugby contgract with the Perth-based Western Force, issued a statement.
"I want to apologise for any issues that I have caused and I want express my respect for my teammates, the Wallabies and the jumper," he said.
"There is nothing more important and rewarding to me than representing my country.
"I want to say again that I do appreciate the impact that some of my actions have had on my team and the sport in general.
"I recognise that given my actions and the circumstances it is best for the team and myself to go in different directions in the short term. "
I remain focused on earning my place back with the Wallabies and will be looking for the right opportunity to do this."
STRIFE AND TIMES OF WAYWARD WALLABY JAMES O'CONNOR:
April 2008: Becomes youngest Super Rugby debutant at 17 when he comes off the bench for the Western Force against Queensland Reds.
November 2008: Becomes second youngest Wallaby when, at 18, he makes his debut off the bench against Italy in Padova.
June 2009: Scores three tries in his Wallabies starting debut against Italy in Canberra but also sanctioned for being involved in a food fight at the team hotel the same week.
November 2010: Allegedly involved in an altercation with teammates Quade Cooper and Kurtley Beale in Paris.
April 2011: Force withdraw contract extension after O'Connor demands the club agrees to key performance indicators.
June 2011: Confirms deal with Melbourne Rebels from 2012, infamously declaring he was doing "what's best for my brand".
August 2011: Suspended for one match and given a suspended fine after sleeping in and missing the Wallabies' official World Cup squad announcement.
June 2013: Photographed at a Melbourne fast food outlet at 4am in the week of the Wallabies' second Test against the British and Irish Lions.
June 2013: Misses team bus to the Wallabies' final training session before third Test against the Lions in Sydney.
July 2013: Fails to attend Wallabies' team meeting after a loss to the Lions at ANZ Stadium.
July 2013: Released by Super Rugby side Melbourne despite being a Wallabies regular. The Rebels state the franchise was "entering the next phase of development".
September 2013: Removed by Australian Federal Police from Perth Airport after Wallabies' win against Argentina. AFP claims he was intoxicated.
September 2013: Suspended indefinitely with the ARU to investigate incident.
October 2013: Parties mutually agree he is released from ARU contract for remainder of 2013 and will have no national contract in 2014. He won't be picked for the November tour to Europe but can still play for the Wallabies next year for match payments only if he remains in Australia.