The 27-year-old, who returned last year after seven years off the professional circuit, had won the first set against compatriot Sam Querrey in a tiebreak and was level at 1-1 in the second with the 20th seed when he suffered the injury.
"I didn't see what happened," Querrey said. "I hit a ball, and then he hit a ball long. I was looking at the ballkids to grab balls for my serve, and then I looked back and he was on the ground.
"And then just asking him, he said he kind of just felt his knee almost buckle and kind of heard like a pop or a snap. He didn't know if it was bones or a tear, but he couldn't straighten it, couldn't walk.
"I feel awful for him."
Runner-up at the French Open juniors in 2003, Baker was working his way up the senior rankings in 2005 when he first felt an injury in his left hip, which required surgery.
That began a nightmare run of two left hip surgeries, a right hip operation, hernia surgery and right elbow surgery which, with the exception of a couple of matches in 2007, kept him off the tour until 2011.
"He's the last person that deserves anything like that with his five or six surgeries already," added Querrey.
"He does everything right, treats his body great, just trying to come back, and then something like that happens, it's just so unlucky."
Baker gave it one final go last year and went from world number 456 to 57 at the start of this year's first grand slam, taking in a run to the last 16 as a qualifier at Wimbledon on the way.
His victory in the first round at Melbourne Park against Alex Bogomolov Jr of Russia on Monday was his first at the Australian Open and he had hoped to get back into the top 50 in the world by May.
"In my mind he's a top 50 player and he can beat guys who are top 20, top 10," Querrey said.
"I think if he can heal quickly or if it takes a year, I think he can get right back where he is right now. He's talented, he's good enough."
Querrey, the sole American men's seed this year in the absence of injured compatriot John Isner, will now meet Swiss Stanislas Wawrinka for a place in the fourth round.
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