Kyl, the second-ranking Republican in the Senate, said at a news conference that it was time to give someone else a shot at the seat he's held since 1994.
"There is no other reason than the fact it is time," Kyl said of his decision to retire after 2012. "It is time for me to do something else and time to give someone else a chance."
Kyl, 68, whose father was a congressman from Iowa, served 10 years in the U.S. House before being elected to the Senate. He was re-elected twice, most recently in 2006 when he beat developer Jim Pederson, a former state Democratic Party chairman.
"I think it's a big loss for the country," Senate Republican Leader Mitch McConnell said of his No. 2 at the Conservative Political Action Conference, an annual gathering of party activists. "The good news is that he'll be here for the next two years."
Kyl said he'll spend those years forming a coalition with other senators who have announced their retirements to work without political pressures on tough issues like immigration reform. He said he does not know what he will do after he leaves office, but it won't involve elected office.
"Some people stay too long, and there are other things to do in life," Kyl said. "I never expected to be in office for 26 years."
The Democratic Senatorial Campaign Committee said Kyl's decision made the seat "a prime pickup opportunity.
Democrats have won several statewide races in the past decade, but Republicans still lead in voter registration and were hugely successful in the midterm elections.
"This is the Republican Party's seat to lose," said Doug Cole, a Republican political consultant who is an adviser and former campaign aide to Republican Gov. Jan Brewer. "We have a deep bench of potential candidates whereas the other party's bench is lacking."
Rep. Gabrielle Giffords had been mentioned as a strong Democratic candidate for the seat before she was shot in the head at a political event one month ago.
Giffords is undergoing therapy at a Houston rehabilitation center, and her status as a potential candidate for re-election to the House or the Senate seat is unknown.
Kyl has a reputation as a hardworking conservative who toiled on home-state and national issues, particularly ones involving national defense and judiciary topics, while being overshadowed for years by the state's senior senator, fellow Republican John McCain.
Kyl most recently made headlines for his opposition to a U.S.-Russia nuclear treaty that was a top foreign policy priority of President Barack Obama.
He entered the Senate by winning a seat held by Democrat Dennnis DeConcini, who did not run for a fourth term. He defeated Democrat Sam Coppersmith, a one-term U.S. representative, by a nearly 3-2 margin.