The move came two days after cabinet ministers submitted their resignations alleging a lack of cooperation from members of parliament.
In a televised address, the emir of the oil-rich Gulf Arab state said he took the decision because of "irresponsible behaviour" and in order to "safeguard national unity".
"For the sake of protecting the country and the people from irresponsible behaviour that has exceeded the limit… and in order to safeguard national unity, I have decided to dissolve parliament and call on the Kuwaiti people to elect a new parliament," the emir said.
He said that regional and international developments "required a serious revision of our situation."
"There is no place in this country for fanaticism or allegiance to a sect, a tribe or a social class at the cost of the nation," Sheikh Sabah said.
Kuwait has been experiencing sectarian tensions after members of the Shiite minority held a rally to mourn former Lebanese Hezbollah leader Imad Mughnieh who was killed in a car bombing in Damascus last month.
The emir last dissolved parliament in May 2006 following a bitter confrontation between the government and opposition MPs over reducing the number of electoral districts.
This is the fifth time that parliament has been dissolved in Kuwait which became the first Gulf Arab nation to embrace parliamentary democracy in 1962.
In the general elections that were held in June 2006, the nationalist and Islamic opposition scored a resounding victory occupying a majority in the 50-member house.
Sheikh Sabah on Tuesday cut short a private visit abroad to settle the latest crisis in OPEC’s fourth-largest producer before holding talks with parliament speaker Jassem al-Khorafi, the crown prince and with the prime minister.
The emir had the option of either accepting the government’s resignation and naming a new premier or issuing a decree dissolving parliament and calling early polls.
The government blames parliament for the crisis, but the speaker argued that the government should share responsibility.
"It is unfair to hold parliament responsible for all the negative issues because ministers also contributed to the crisis," Khorafi told reporters outside parliament before the emir’s decree was announced.
Over the past two years, Kuwait has gone through several political crises triggered by power struggles, the resignation of four governments, dissolution of parliament and general election in 2006.
The emir had faced calls to sack the government, appoint a new premier to replace Sheikh Nasser Mohammed al-Ahmad al-Sabah and hold early parliamentary polls.
Leading liberal MP Ahmad al-Mulaifi earlier repeated calls that the government should go, and for changes within the ruling Al-Sabah family. He said the premier had failed to carry out reforms and resolve the crisis.
He also called for the appointment of a prime minister from outside the Al-Sabah ruling family.
But Kuwaiti commentators said earlier that neither dissolving parliament nor sacking the government would resolve the chronic political dilemmas in the emirate.
"The crisis will not be resolved by sacking the government or its head. It will not be resolved by dissolving parliament… or even by suspending democratic life," columnist Madhi al-Khamees wrote in daily Awan.
"We badly need to establish a party system under which the government is formed from parliament on the basis of a clear programme," Khaled al-Ali said in the Al-Wasat newspaper.
Political parties are banned in Kuwait and elections are fought on an individual basis, though groupings are allowed to operate. Unlike Western-style democracy, the prime minister is picked from the Al-Sabah family.
Kuwait, with a native population of just one million, besides 2.2 million foreign residents, sits on about 10 percent of global crude reserves and pumps 2.5 million barrels per day.
