The 35-year-old man was arrested in Tempe, a southern suburb of Sydney, on Monday morning because he fitted the description of the gunman who is thought to have shot Peter Falconio.
But his alibi makes it impossible for him to have been anywhere near the scene of the ambush on an isolated road 150 miles north of Alice Springs in the Northern Territory.
A police spokeswoman said: "There was always a problem with his location at the time of the event. As a result we have now discounted him from the official investigation."
The man, who was arrested after a member of the public spotted him on an area of parkland in Tempe, was last seen in Sydney four days ago.
But the chances of him driving the 1,860 miles from the scene of the attack to Sydney by the time he was last seen were regarded by police as an impossibility.
Mr Falconio, 28, is still missing after he and his girlfriend Joanne Lees, 27, were attacked by a gunman 10 days ago.
Hopes 'dashed'
Speaking from the family home in Hepworth near Huddersfield, his brother Nicholas, spoke of the family's anguish as the search for him continues.
Referring to the arrest he said: "It's just another hope raised and dashed. This isn't the first time it has happened.
"We are finding it more difficult as the search goes on and on. It's just the waiting.
"We just take one day at a time and just hope they catch him - the sooner the better - because the longer it goes on the harder it will get."
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On Monday Ms Lees denied reports that she had criticised police leading the hunt for her boyfriend's attacker.
She had been quoted in Australian newspapers complaining that she had been grilled for 18 hours by police on the morning she escaped.
But Mr Falconio's brother Paul, who has flown out to Australia,
read a statement on Ms Lees's behalf, denying the comments had been made by her.
"We know that Joanne worked long hours with police during the initial stages of the investigation but she was extremely anxious to assist police."
Ordeal
Ms Lees stepped out in public for the first time since her ordeal on Monday, to go shopping in Alice Springs.
She was shadowed by three plain-clothes police officers, before being driven away to a safe house.
On Monday police lifted roadblocks which have been in place since shortly after the attack.
They said Mr Falconio's killer could have found a way to get round the roadblocks, or left the area before they were put in place.
Ms Lees, from Almondbury, near Huddersfield in West Yorkshire, and Mr Falconio were attacked on the Stuart Highway on 14 July.
Ms Lees said she heard what she thought was a gunshot moments after Mr Falconio got out of the van.
She said the mystery man then pulled her from the vehicle, tied her up and threw her into the back of his van.
Bound and gagged, Ms Lees managed to escape by crawling from the cabin through the opening.
She hid from the gunman for almost six hours before flagging down a passing truck and raising the alarm.
Mr Falconio has not been found, although his blood has been found at the scene.
The pair had stopped their camper van to help a motorist who claimed the vehicle had broken down.
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Related to this story:
Police issue sketch of gunman's truck
(21 Jul 01 | Asia-Pacific)
Outback police to lift roadblocks
(23 Jul 01 | Asia-Pacific)
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