"Chelsea are banned from registering any new players, either nationally or internationally, for the next two entire and consecutive registration periods (transfer windows)," FIFA said in a statement on Thursday.
The English Premier League club described the ruling as "extraordinarily arbitrary" and "totally disproportionate" and said they would appeal.
The decision is a crushing blow for Chelsea. The next window is in January followed by another in the middle of 2010.
The punishment was handed out by world football's governing body following a contractual dispute involving the transfer of reserve team player Gael Kakuta from Racing Lens in 2007.
Following a complaint from Lens, FIFA's dispute resolution chamber ruled Kakuta, now 18, had breached his contract with the French club and that Chelsea had induced him to do so.
The player was ordered to pay 780,000 euros compensation, which FIFA said Chelsea were "jointly liable" for, and he was given a four-month ban from competitive matches.
Chelsea were also ordered to pay "training compensation" of 130,000 euros to Lens.
"This underlines how important contractual stability is for FIFA and football in general," said a FIFA spokesman.
Lens president Gervais Martel told French radio station RMC: "We expected that decision. It's not because you're called Chelsea that you should not respect the law.
"They contacted him when he was not even 16 which is not acceptable. There is a rule you have to respect.
"I don't know what will happen next. I don't expect he will be back with us," added Martel.
"We spend a lot of money on schooling. There's no reason why others should use us and benefit from it."
CHELSEA FURY
The London club were furious at the decision.
"Chelsea will mount the strongest possible appeal," the club said on their website. "The sanctions are without precedent to this level and totally disproportionate to the alleged offence and the financial penalty imposed.
"We cannot comment further until we receive the full written rationale for this extraordinarily arbitrary decision."
Kakuta had been at Lens since he was eight, going through their schooling system. A midfielder, he is a France under-19 international and was due to play in the Sendai Cup in Japan this month.
Hampered by injury, he made only five Chelsea youth team appearances last season and two for the reserves.
He began last season with hamstring problems before being sidelined in February after suffering a double fracture of the ankle in a friendly.
Kakuta's first season was more successful as he finished as the youth team's top goalscorer.
Four years ago Chelsea were fined 300,000 pounds by the Premier League over the "tapping up affair" involving the move of Ashley Cole from Arsenal.
Jose Mourinho, c
