Joint financial support to dual the road at a cost of £850m was established as part of the St Andrew's Agreement in 2006 and construction was expected to start in 2012.
But on Wednesday, it was revealed that the Irish Government would not be supplying the £400m it had agreed to pay out within the 2011-2015 budget.
A spokesperson said: "The Government remains politically committed to this project, however - given the tight fiscal constraints - roads investment will be focused on maintaining existing roads, rather than developing new routes.
"It is therefore not anticipated that significant resources will be available for this project over the medium term."
Chair of Strabane Council says Irish Govt's withdrawal of funding for A5 has set the region back 30 years.
UTV's Gareth Wilkinson on Twitter (GWilkinson_utv)
First Minister Peter Robinson said the Executive must "immediately examine how best to reallocate the £400m that had been set aside for the project".
He added: "This announcement will come as a considerable blow to the local construction industry, which has already suffered greatly during this downturn. It will therefore be our priority to identify projects that will ensure that construction jobs are supported."
Deputy First Minister Martin McGuinness said the road was seen as a "key route for the future economic growth of the North West".
"Successive Irish Governments have expressed their commitment to the project and, at the last meeting of the North-South Ministerial Council (NSMC), the Irish government committed a further £11m to the A5 and A8 projects."
Finance Minister Sammy Wilson said he had impressed upon his counterparts in the Irish Government the importance of maintaining the commitment to the project as recently as last week.
"Indeed we asked them to consider a possible re-profiling of the project," the minister said.
"However, given the current fiscal environment within Republic of Ireland, Dublin ministers indicated that the greater priority was funding urgent schemes within their jurisdiction."
The decision to halt funding to the A5 project "should not alarm" those in the construction industry who expected to be employed during the development, he said.
Significant capital investment resources will now be released from this project for reallocation to other areas within Northern Ireland.
Finance Minister Sammy Wilson
Regional Development Minister Danny Kennedy said: "This news is extremely disappointing with major implications for the A5 and A8 schemes. This is a commitment of the Irish Government, confirmed at the North South Ministerial Council. Clearly it will be a major item for discussion at the NSMC plenary."
The upgraded A5 would have improved access to Donegal via Londonderry and local MP Mark Durkan - who originally negotiated with the Irish Government for funding to be earmarked for the project during his term as Finance Minister - said he was very disappointed at the withdrawal of funding.
"If we cannot get a timeline and profile levels of Irish Government spend there is a danger that the department in the North could feel tempted or forced to divert its intended spend elsewhere or just reduce their overall capital commitment."
More than 2,000 people lodged their objections to the dualling of the A5 during the formal consultation period which ran from last November to January 2011.
The withdrawal of funding has come as good news to many landowners and farmers who objected to the use of their land during the redevelopment.
UTV's Gareth Wilkinson said anti-A5 campaigners were "delighted the Irish Government has pulled funding and say homes and farms have been saved".
Charity Sustrans, which encourages people to travel by foot, bike or public transport for more of the journeys, also welcomed the decision to withdraw funding.
"A proportion of the withdrawn money could improve everyday travel for the people of Northern Ireland with targeted investment in urban and rural areas to increase people's travel choices, enhance quality of life and help the economy," said Sustrans' Northern Ireland Director, Steven Patterson.
"The Northern Ireland Assembly must now produce a plan of how a good proportion of the money that had been earmarked for the A5 is to be spent on transport, so that the huge opportunity for transforming how people travel for their everyday local journeys can be seized."