The shock result for Madrid was softened hours later when league leaders Barcelona were held at home by Real Betis to 1-1. That meant Hansi Flick's side extended their lead to only four points over their fierce rivals.
There are eight rounds left including a clasico in May.
Hugo Duro came off Valencia's bench and headed home the winner that silenced Santiago Bernabeu Stadium deep in stoppage time.
Goalkeeper Giorgi Mamardashvili saved Vinícius' early penalty and moments later Mouctar Diakhaby headed the visitors in front in the 17th minute.
Vinícius scored from close range to equalise in the 50th, but Mamardashvili and the defence held on until Duro struck and gave Valencia their first away win of the season.
"It is much harder now to fight for the league, but we only have one idea and that is to fight until the end because we still have a chance after this game," Madrid manager Carlo Ancelotti said.
He had to play third-string goalkeeper Fran González, who made his first-team debut for Madrid at age 19, because Thibaut Courtois and Andriy Lunin were injured.
The victory confirmed Valencia's improvement since Carlos Corberán replaced Ruben Baraja in December. They have risen from the relegation zone to 15th place and seven points from danger.
Some jeers were heard from Madrid fans after Vinícius missed the penalty earned by Kylian Mbappé when his low and centred shot was easily saved by Mamardashvili. The Brazil forward also missed a penalty in a recent Champions League game against Atletico Madrid.
Two minutes later, Diakhaby, who returned from a serious leg injury in January, rose over Antonio Rudiger and headed in André Almeida's corner kick.
Vinícius partly redeemed his penalty miss when he was left unmarked at the far post to stab in a corner headed on by Jude Bellingham.
But Madrid pressed for the win and instead ended up losing the game when they were unable to defend a quick attack that finished with Rafa Mir's tight cross that Duro thumped past a flailing González.
In a matchup of the hottest teams in La Liga, Betis rallied to pull level and then withstood a second-half onslaught at Barcelona.
Gavi Páez drilled a low strike home after a nice set-up by Ferran Torres to give Barcelona the lead in the seventh.
Fifth-placed Betis levelled though Natan's header 10 minutes later, and goalkeeper Adrian San Miguel and former Barcelona defender Marc Bartra turned back a slew of shots by the hosts to split the points.
Also, Celta Vigo won at Mallorca 2-1, while Alaves won at Girona 1-0.
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