The 26-year-old Spaniard, who crashed out of Wimbledon in the second round in June, said he needed more time to recover from an injury that kept him from defending his Olympic title at the London Games.
"Coming to Toronto is always one of the highlights of my season so I'm very disappointed that I can't play there this year," the 11-times grand slam champion said in a statement.
"I was planning on coming to Toronto and did everything I could to be ready but I still need some more time to recover."
Despite winning a record seventh French Open title this year, Nadal has fallen to three in the world rankings and the state of his knees is sure to become a topic of debate leading into the August 27-September 9 U.S. Open, the year's final grand slam.
Additional main draw withdrawals for the August 4-12 Toronto Masters as of Thursday are David Ferrer (Spain), Gael Monfils (France) and Fernando Verdasco (Spain).