Madrid looked the more composed and dangerous in the first half with Cristiano Ronaldo back in Manchester after his spell with United tormenting his former foes.
Again it was City's failings at the back which cost them dear. After only ten minutes a deep Angel Di Maria cross found Maicon wanting and Karim Benzema was unmarked to sweep home from close range.
By the end of the first 45 minutes the Spaniards should have made the game safe as Ronaldo had a shot cleared off the line, Sami Khedira was foiled by keeper Joe Hart and other chances came their way against an uncertain home defence.
City probably felt they still had a chance as Madrid had kept just one clean sheet in their last ten Champions League games and began the second half with some urgency, but for all their possession the final quality ball was lacking.
Their best chance fell just after the hour as Maicon's cross took s deflection and Aguero looked certain to level until Casillas made a marvellous block on the line.
But City's pressure told with 16 minutes remaining. Arbeloa brought down Aguero, was shown red and the forward sent Casillas the wrong way to restore parity.
The host's continued to press but Madrid held firm, even with 5 minutes of added time, leaving the City fans to wonder what might have been had they shown the same commitment in the opening period.
Referee: Gianluca Rocchi (ITA)
Venue: Etihad Stadium
Man City scorers: Aguero pen 74
Real Madrid scorers: Benzema 10
Yellow cards: Garcia (MANC), Nasri (MANC), Yaya Toure (MANC), Maicon (MANC), Zabaleta (MANC), Arbeloa (RM), Alonso (RM), Ramos (RM)
Red Card: Arbeloa (RM)