Italy goalkeeper Gianluigi Donnarumma was the hero for the winning side in the shootout, while substitutes Marcus Rashford, Jadon Sancho and Bukayo Saka failed to convert from the spot for England.
Luke Shaw had struck the fastest goal in a Euro final to put England ahead in the second minute. Harry Kane fed Kieran Trippier on the right and his glorious cross was drilled home first time by left back Shaw.
But Leonard Bonucci drew Italy level in the 67th when England goalkeeper Jordan Pickford pushed Marco Verratti's header against the post and Bonucci pounced to slot in the loose ball.
England's captain Harry Kane said it will be a long time before his team can forget the pain of their final loss, but commended the squad's effort to reach the country's first Euro's final.
"[It's a] tough one to take for sure, penalty shootouts are the worst way to lose, its obviously disappointing but we've got to hold our heads high we had a fantastic tournament," Kane said.
It hurts now and its going to hurt for a long time of course but the boys should be proud of themselves."
Former England striker Alan Shearer sympathised with the team that came so close to a historic victory.
"Football is a cruel, cruel game at times. Those boys have performed heroically for a month, such a shame that it has to come down to a situation like this," Shearer said.
Meanwhile, former Italy fullback Gianluca Zambrotta was gleeful.
"An unforgettable night for our Azzurri! What a fantastic achievement for Roberto Mancini and his team. They deserved to win this second Euro title, and their performance from the opening game in Rome one month ago has been perfect!" he said.
"You have added more history to our national team and you all should be very proud! Congrats Champions, now it'ss time to celebrate all together!"
Rio Ferdinand, who played 81 times for England and scored three times, thanked Gareth Southgate's side for their efforts.
"Obviously, huge disappointment. But as you can see, the fans clapping the players. They have brought us a joy, that definitely my generation and below have never felt watching an England team," he said.
"They lifted the country up when we needed it. It's a harsh, harsh game when it gets to this stage. It's a painful way to lose it ... Italy will enjoy it and credit to them."
Former England midfielder Frank Lampard praised both sides.
"We've seen individuals and the (England) team grow. We've seen the nation grow behind the team. Italy controlled the elements of the game. We must give them credit. They deserve their victory," he said.
"The effort this England team put in, we felt it so dear to our hearts and we wanted them to get over the line. Finals are won by moments. It can go any way. Penalties are so tough. It's the nature of the game."
England remain without a major trophy since 1966.