The video, which has been authenticated by the US National Security Council and has drawn international condemnation, was circulating on social media after being released by the killers.
It shows 40-year-old photojournalist James Foley, who went missing in Syria back in 2012, kneeling in the desert beside a man dressed in black and with his face covered.
Brandishing a knife, the extremist seems to speak with an English accent when he accuses the US of "plotting against" the Islamic state.
Appearing to be under duress, his captive says: "I call on my friends, family and loved ones to rise up against my real killers, the US government - for what will happen to me is only a result of their complacency and criminality."
The video shows the journalist being attacked before his body and severed head are then displayed.
We would like to remind the public that viewing, downloading or disseminating extremist material within the UK may constitute an offence under terrorism legislation.
Emergency talks have been held by Prime Minister David Cameron, while British intelligence services are trying to identify the killer.
"Let me condemn the barbaric and brutal act that has taken place and let's be clear what this act is - it is an act of murder, and murder without any justification," Mr Cameron said.
"We have not identified the individual responsible, but from what we have seen it looks increasingly likely that it is a British citizen.
"This is deeply shocking. But we know that far too many British citizens have travelled to Iraq and travelled to Syria to take part in extremism and violence."
Mr Cameron added that efforts to prevent that must be re-doubled - taking passports of those intending to travel for such purposes, arresting and prosecuting those participating in extremism, and removing extremist material from the internet.
"And that is what this Government will do," he said.
"I have been very clear that this country is not going to get involved in another Iraq war. We are not putting combat troops, combat boots on the ground - that is not something we should do."
Jim was taken from us in an act of violence that shocks the conscience of the entire world.
President Barack Obama
The chilling video footage goes on to show the IS extremist single out US President Barack Obama, threatening that further actions in Iraq by America "will result in the bloodshed of your people".
A man identified as another captured journalist, Steven Sotloff, is then shown - with the warning that his life depends on Mr Obama's "next decision".
On Wednesday afternoon, the president held a press conference in which he condemned the IS organisation as "a cancer that must be extracted so it does not spread".
Mr Obama paid tribute to James Foley and his work, having visited his family to express his sorrow and sympathy, adding that the journalist's life "stands in stark contrast to his killers".
"We will continue to confront this hateful terrorism and replace it with a sense of hope and stability," he said.
"That's what Jim Foley stood for. A man who lived for his work, who courageously told the stories of his fellow human beings, and who was liked and loved by friends and family."
Mr Obama added: "No faith teaches people to massacre innocents."
On Facebook, James Foley's mum Diane paid tribute to her son, but also pleaded for the lives of the remaining hostages.
"We implore the kidnappers to spare the lives of the remaining hostages," she said.
"Like Jim, they are innocents. They have no control over American government policy in Iraq, Syria or anywhere in the world."
Later, at an emotional press conference, the journalist's parents and his brother all spoke of their pride - with dad John saying: "You know Jimmy's free and we know he's in God's hands and we know he's in heaven, so we're so proud of him."
We have never been prouder of our son Jim. He gave his life trying to expose the world to the suffering of the Syrian people. He was an extraordinary son, brother, journalist and person.
Foreign Secretary Philip Hammond took part in the talks with David Cameron and key officials.
He has already brand the video an "appalling example of the brutality of this organisation".
He added: "We are absolutely aware that there are significant numbers of British nationals involved in terrible crimes, probably in the commission of atrocities, making jihad with IS and other extremist organisations.
"This is something we have been tracking and dealing with for many, many months."
Mr Hammond indicated that military support could be stepped up to help stop the advance of IS, but again stressed that UK combat troops would not be returning to Iraq.
Twitter is actively suspending accounts found to be sharing graphic images of the beheading, while many users have been encouraging others not to watch or share the video.
Using the hashtag #ISISmediablackout, they urged people to share photos of the smiling photojournalist before his capture instead.
Google-owned YouTube is also taking steps to remove videos of the killing and close accounts belonging to terrorist organisations.