Wolves shaded a tight encounter with an 86th-minute goal by Sam Whittall enough to inflict a rare defeat on Manchester United's Under-21s.
The Reds needed a win to secure a place in the semi-finals of the Barclays-sponsored competition but, although Ryan Tunnicliffe hit the bar, it means there was no way past the Wolves defence in 180 minutes following the goalless draw at Moss Lane.
United started well with Adnan Januzaj forcing a diving stop out of Aljaz Cotman in the 10th minute and Tunnicliffe smashing against the woodwork after driving forward from a Larnell Cole pass. Januzaj blasted another attempt wide from the edge of the box but the hosts improved towards the interval.
Zeli Ismail beat Michele Fornasier and Ben Amos but could only hit the side-netting from a tight angle while efforts by Jack Price and Whittall brought the best out of Amos. A bobbly surface did not help either side and the play became scrappy with the tackles starting to fly in.
Januzaj was narrowly off target again soon after a burst forward by Tunnicliffe and the Belgian released the energetic midfielder with a glorious pass but a combination of goalkeeper and defender kept him out.
United still pressed with Jesse Lingard firing over and a tantalising Januzaj cross narrowly evading Tyler Blackett, playing in a much more advanced role, as the opener refused to come despite the visitors looking likeliest to score.
Instead, against the run of play, the outstanding Tom Thorpe conceded a corner and a melee ensued from the cross. With appeals for handball against Lee Evans turned down, Whittall was allowed to sweep in from close range following a real scramble.
Goalkeeper Amos went forward for a couple of Januzaj corners late on but there was no way back for Warren Joyce's side with Reece James having the final attempt but screwing his ambitious drive well wide of goal. The Reds are next in action at Old Trafford on Tuesday against West Brom with qualification still within reach.