Hodgson leaves Anfield after an unhappy six-month reign after taking over from Rafael Benitez with Liverpool having suffered a ninth Premier League defeat on his watch at Blackburn this week.
That left the embattled side languishing in 12th position, four points above the relegation zone.
In a statement on the club's website, principal owner John Henry said: "We are grateful for Roy's efforts over the past six months, but both parties thought it in the best interests of the club that he stand down from his position as team manager.
"We wish him all the best for the future."
Hodgson added: "Being asked to manage Liverpool football club was a great privilege.
"Any manager would be honoured to manage a club with such an incredible history, such embedded tradition and such an amazing set of fans.
"The club has some great, world-class players, with whom it has been a pleasure to work and I wish the entire squad well for the rest of the season.
Dalglish steps in for his second stint in the Anfield hot seat - his first spell between 1985 and 1991 harvested three league titles and two FA Cup titles.
Speaking about the decision to put the Liverpool legend in charge for the rest of the season, Henry added: "We are delighted that Kenny Dalglish has agreed to step in and manage the team for Sunday's FA Cup tie at Old Trafford and for the remainder of the season.
Hodgson becomes the third Premier League manager to be axed this season after Chris Hughton at Newcastle and Sam Allardyce at Blackburn.
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