The ??359m Independent Living Fund pays out an average of ??300 a week, to help people pay for carers so they can live at home and not in a care home.
It was already shut to new applicants for this year and will now shut to new claims permanently, said the minister for disabled people, Maria Miller.
Payments to existing users are to continue until 2015.
Ms Miller said: "An independent discretionary trust delivering social care is financially unsustainable."
But Richard Hawkes, chief executive of disability charity Scope, said the decision to phase out the fund was "bemusing".
"The fund is comparatively very small and is designed to support disabled people to live at home rather than in care homes," he said.
"It's hard to see how phasing out this fund will do anything but narrow down options and push people towards greater dependence on the state."
The phased closure was described as "foolhardy and lacking in humanity" by Labour peer Lord Morris of Manchester.
Lord Morris, who was the first minister for the disabled, said: "This will not save money. If you make it harder for disabled people to live at home, it will cost more because more of them will have to be in hospitals and other places of full-time care.
"It will mean far more of them having to be in institutional care at far greater cost to the taxpayer."
The government said local authorities had a statutory responsibility to provide social care support to their residents.
And it said it remained its priority to safeguard the position of the recipients of the fund.
It said it would carry out a formal consultation next year on how best to continue to support existing users.

Bradley Onfroy and Josie Hollis are accused of killing Jordan Hill.
Mr Hill died in hospital after being found with injuries at a flat in Southey Avenue, Sheffield, on 23 March.
Mr Onfroy, 31, of Badger Close, Sheffield, and Ms Hollis, 24, of no fixed abode, appeared at Sheffield Crown Court and were remanded in custody to stand trial on 20 October.
They also denied robbery.
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Kakuta, 23, moved to Stamford Bridge from Lens in 2007 and was on loan at Rayo Vallecano last season, where he played 35 games.
The Frenchman played 16 times for the Blues, but spent time on loan at six different clubs.
In September 2009, Chelsea were barred from signing new players after being found guilty of inducing Kakuta to break his contract with Lens.
The ban was lifted by a court in February 2010 after the two clubs reached an agreement on his signing.
It is thought Sevilla have had to pay a fee for Kakuta because he is under 24.
In October 2014, failed footballer Medi Abalimba was sentenced to four years in prison after masquerading as Kakuta.
Manchester Crown Court heard Abalimba went on a £20,000 shopping spree at Selfridges, stayed at top hotels and even hired a helicopter.
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City are four points above the Premier League relegation zone and they want to sign a striker in January.
Paloschi, 26, has scored eight goals in 21 league games for Chievo this season.
Starting his career at AC Milan, the Italian also played for Parma and Genoa. He joined Chievo in 2011 and has scored 42 goals in 144 Serie A appearances.
Paloschi has represented Italy at Under-21 level, scoring in their 2-1 defeat to Wales at Swansea's Liberty Stadium in 2009.
He lined up alongside the likes of Milan and former Liverpool forward Mario Balotelli in a game won by Aaron Ramsey's spectacular strike.
Paloschi could now be about to link up with compatriot Francesco Guidolin, who was appointed Swansea's head coach earlier this month.
Former Udinese manager Guidolin guided the Swans to a 2-1 win at Everton in his first game in charge, the Welsh club securing back-to-back victories for the first time this season having previously beaten Watford.
Despite the encouraging start to Guidolin's reign, Swansea are still 15th in the Premier League table, with only bottom side Aston Villa scoring fewer goals so far in this campaign.
A fund which supports more than 21,000 people with severe disabilities is to be phased out by 2015.
[NEXT_CONCEPT]
A man and a woman have denied the murder of a 21-year-old who was stabbed.
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Chelsea's out-of-contract winger Gael Kakuta has joined La Liga side Sevilla.
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Swansea City are in talks with Chievo about signing striker Alberto Paloschi for a fee of around £8m.