The transport secretary told the Commons on Monday that Stagecoach would also be walking away much sooner than planned, as the service's future was "much more urgent" and changes were required in "the very near future".
The franchise had been due to end in April, but the Government has previously announced that Virgin will run services until April next year before a new franchise was expected to be created to run the West Coast and HS2 services when the high speed line is built in 2026.
Grayling said Stagecoach had miscalculated over the East Coast franchise and would lose £200m and only be allowed to run the service on a not-for-profit, short-term basis.
"That Chris Grayling awarded a profitable contract to Virgin and Stagecoach on the West Coast while simultaneously confirming the same companies have collapsed on the East Coast shows Government policy is in chaos. That is our responsibility".
Responding to the Transport Secretary's confirmation that the East Coast Mainline franchise will end within months, Cllr Judith Blake, Leader of Leeds City Council and who speaks for the West Yorkshire Combined Authority on transport issues, said: "Passengers will be angry and disappointed that the improvements to East Coast Mainline services they were promised have been put in doubt less than three years after this franchise began, the latest in a series of franchise failures on this line".
Earlier, the transport secretary had said regarding the east coast line: "It has now been confirmed that the situation is urgent. and the contract will only last in its current form for a small number number of months".
"We are also continuing our discussions with the Department for Transport about new contractual arrangements to facilitate the transition to the planned new East Coast Partnership in 2020".More news: New England Patriots officially lose Josh McDaniels to Indianapolis Colts
More news: TMC upset with SP, AAP over Rajya Sabha disruptions
More news: Jones lauds 'wonderful' start to Six Nations fixtures
In the meantime, Mr Grayling said that the line would continue to operate as usual.
Since then, the DfT has conducted detailed analysis and has notified the franchise that it has breached a key financial covenant.
The intention is that Alstom would hold 20% of the share capital of the train operating company if the Stagecoach bid were to be successful.
"The problem is that Stagecoach got its numbers wrong".
The government could be forced to renationalise the East Coast mainline rail service.
Shadow transport secretary Andy McDonald attacked the "failed franchise system". "It's increasingly clear that he doesn't care about taxpayers, rail passengers or the rail industry itself".
But in a statement tonight Stagecoach chief exec Martin Griffiths claimed the Government had "rigorously tested" its bid at the time, adding: "I was personally told at the time it was the highest quality bid they had ever seen".