Substitute Oscar Cardozo scored the decisive spot-kick at the Loftus Versfeld stadium after Japan's Yuichi Komano had smashed his penalty against the crossbar.
Paraguay will play either Spain or Portugal, who meet later Tuesday, in the quarter-finals on Saturday.
The shoot-out was needed after 90 minutes of regulation time and 30 minutes of extra time failed to separate the two teams in a tense affair of few chances.
Yoshito Okubo had an early chance for the Asian side but shot well wide while at the other end Edgar Benitez couldn't keep his header down from Roque Santa Cruz's inviting cross.
The game briefly exploded into life on 21 minutes as Paraguay striker Lucas Barrios sneaked in behind the defence with a lovely little drag back but then he prodded his shot straight at goalkeeper Eiji Kawashima.
Less than 60 seconds later Daisuke Matsui ran onto a loose ball and tried his luck from distance only to see his curler crash against the Paraguay crossbar.
On 29 minutes Manchester City striker Santa Cruz should have done better when the ball dropped to him 12 yards out, but he rushed his left foot volley and dragged the ball wide.
Japan star Keisuke Honda set his sights five minutes from the break but his left-foot effort from 20 yards drifted wide.
At the start of the second period Nestor Ortigoza opened up the Japanese defence to create a shooting opportunity but Yuto Nagatomo slid in to make a goal-saving block.
Yuji Nakazawa was next to dive in and stop a goalbound effort from Benitez as Paraguay started to turn the screw.
Cristian Riveros then met a Claudio Morel cross with a firm header which went straight at Kawashima.
Five minutes into extra-time, Barrios's header from Morel's cross landed in Kawashima's arms before Nelson Valdez turned sharply on the edge of the box to create a half chance that Kawashima smothered.
At the other end Paraguay captain and keeper Justo Villar palmed away a fizzing Honda free-kick.
Japan had a late opportunity on the counter attack but after Shinji Ozakazi's backheel released Keiji Tamada the Nagoya Grampus Eight forward opted to cross instead of shoot and the chance went begging.
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