Rees produced one of the boxing upsets of 2007 when he took the title from Soulyemane M'Baye.
But from the third round on, when his nose started to bleed, Rees - whose trainer is Enzo Calzaghe, the father and coach of undisputed super-middleweight champion Joe, started to be picked off by Kotelnik.
And the challenger finished the bout 30 seconds from the end of the last round, and what would otherwise most likely have been a crushing points victory, when he dropped Rees with a powerful right hand.
Defeat was the Welshman's first in 28 bouts as professional and it also meant Enzo Calzaghe had seen another of his fighters lose a world title this month after Enzo Maccarinelli, the former World Boxing Organisation (WBO) cruiserweight champion, was knocked out by fellow Briton David Haye.
"He hits so hard," the 27-year-old Rees told Setanta Sports after his defeat. "I didn't think he was going to hit that hard.
"He caught me on my right ear in the third round.
"I didn't know what was happening then to be honest.
He added: "I'll be back. It's my first career loss - I'm only 27."
Enzo Calzaghe praised Rees's bravery, saying: "Sometimes you can lose and still be champion. That's tremendous, tremendous heart."
Kotelnik said he'd always been prepared to go 12 rounds. "I expected Rees to be that strong because he's the world champion and I expected to go the distance with him."