N-Dubz star Tulisa had been accused of boasting that she could "sort out" cocaine for the journalist, putting in touch with her rapper friend Mike GLC, who supplied the Class A drug.
But Judge Alistair McCreath doubted the "inconsistent" evidence from Mahmood, telling the jury: "There are strong ground for believing Mr Mahmood told me lies."
He said that Mahmood most likely lied "to conceal the act he had been manipulating the evidence", adding that a trial cannot go ahead if the prosecution has been "tainted... by serious misconduct".
A beaming Tulisa could be seen in the dock after the judge announced his decision and she hugged friends and family when leaving court.
Punching the air as she left, the singer began crying and hugged supporters including her PA, Gareth Varey.
**CLICK HERE TO SEE FAB PICTURES OF TULISA**
Standing outside court, Tulisa made a defiant statement saying she had "never dealt drugs" and had "never been involved in taking or dealing cocaine."“This whole case was a horrific and disgusting entrapment”Tulisa
She said: "This whole case was a horrific and disgusting entrapment by Mazher Mahmood and the Sun on Sunday newspaper.
"Mahmood has now been exposed by my lawyers openly lying to the judge and jury. These lies were told to stop crucial evidence going before the jury.
"This evidence shows that I told Mahmood's long-standing driver that I disapproved of drugs, which is the truth.
"It is clear that the driver was pressured to change his statement to strengthen Mahmood's evidence and to damage mine.
"Thankfully the lies have been uncovered and justice has been done."
Confirming that she was "tricked" into believing she was auditioning for a major film role, Tulisa added: "They targeted me at a time when things were going badly for me and they had no mercy.
"Mahmood got me and my team completely intoxicated and persuaded me to act the part of a bad, rough, ghetto girl.
"They recorded this and produced this as evidence when I thought it was an audition. It was a terrible thing to do.
"As my lawyer said at the outset, we have now succeeded in exposing the real culprits and, most importantly, the real liar."
She added: "As someone who has had my life ruined for the last year I strongly believe that this type of entrapment should not be allowed to happen to anyone.
"I urge both the police and News UK to investigate Mazher Mahmood and his team and
"I have not been able to work for a year, and I am now looking forward to resuming my career."
The Sun have now suspended Mahmood "pending an immediate internal investigation".
A spokesman said: "We are very disappointed with this outcome, but do believe the original investigation was conducted within the bounds of the law and the industry's code.
"This was demonstrated by the CPS (Crown Prosecution Service) decision to prosecute.
"The Sun, of course, takes the judge's remarks very seriously.
"Mr Mahmood has been suspended pending an immediate internal investigation."
Tulisa has constantly denied brokering the deal, which was exposed in the Sun on Sunday newspaper last June.
The court heard that the collapse of the case hinged on evidence given by Mr Mahmood about a statement given to police by a driver called Alan Smith who picked up Ms Contostavlos from a hotel in London in May last year.
Mr Smith originally suggested that he had heard the star talking disapprovingly about drugs but "changed his mind" after a conversation with the undercover reporter, the court was told.
During a pre-trial hearing, Mr Mahmood was asked: "Did you subsequently ask or find out, discuss with Mr Smith anything that was said in the car?"
He replied: "No."
Asked if at any stage he discussed Tulisa saying she "disapproved" of drugs, he also said no.
But the judge said he gave answers which were "entirely inconsistent" when he gave evidence about the same topic at the trial last week.
She was so taken in she offered to quit her role on The X Factor to take up the movie offer.
Her lawyer Jeremy Dein claimed she was manipulated into incriminating herself by Mr Mahmood to give him a “sensational” story.
He said the journalist had made it clear to the singer the role was for a “bad girl” and she was more suitable than Kate Winslet.
It was also claimed that Mahmood had spiked her drink, something he denied.
Mike GLC – real name Michael Coombs – pleaded guilty before the start of the trial to supplying half an ounce of cocaine but he also walked free after judge said the case cannot proceed against him.
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