Ivan Klasnic headed Croatia in front with seconds left - only for Turkey's Semih Senturk to volley the equaliser with the last kick of the game.
Arda Turan, Semih and Hamit Altintop scored in the shoot-out for Turkey.
Luka Modric, Ivan Rakitic missed for Croatia and Turkey keeper Rustu saved the deciding kick from Mladen Petric.
It was astonishing finish to a dreadful game, especially for Turkey keeper Rustu, who made an awful error that looked to have given Crotia victory before his free-kick set up Semih for the leveller as referee Roberto Rosetti prepared to blow the final whistle.
Croatia coach Slaven Bilic, who had celebrated what he thought was a famous victory with his players only seconds earlier, could not lift his deflated players and they looked a beaten side even before the penalty shoot-out.
He said afterwards: "My players put in a heroic performance and I can have no complaints about any of them.
"Penalties are a lottery and the players felt confident enough to take the spot kicks.
"I thought that it was finished, that we had won and then in a flash this fantastic goal by Semih.
"After that, it was the drama of penalties. Oh well life goes on. Tomorrow is another day. We will now get back into the groove in the World Cup qualifiers."
He added: "I want to congratulate both teams for a great game of football.
"This match shows why it's the most dramatic and most popular game in the world.
"I congratulate Turkey but we have beaten beaten better opponents and the last two minutes I cannot begin to describe, both our goal and theirs and then penalties.
"The pain of this defeat will stay with me for a long time.
"It will haunt us forever."
