By dropping the second-round match at the Porsche Grand Prix, Williams will be overtaken by Jelena Jankovic when the new rankings come out Monday, the WTA said. The American gained the top spot when she beat Jankovic in the final of the U.S. Open three weeks ago for her ninth Grand Slam title.
Jankovic plays her first match in the tournament on Thursday against Alona Bondarenko of Ukraine in the second round.
"Obviously I want to be No. 1 but I am not focusing on that,'' Williams said. "I am focusing on winning titles and that goes hand in hand (with getting No. 1). I am not worried, it will come again if I win tournaments. I play to win titles and Grand Slams, although obviously the No. 1 is also on my mind.''
Williams was playing her first match since the U.S. Open after getting a first-round bye in Stuttgart.
She rolled through the first set and appeared to be heading for a resounding victory when things suddenly turned around.
"I started making a lot of errors and I just gave it to her - maybe I started doubting myself,'' Williams said.
Li said she was so nervous at the start of the match, "I had such cold hands.''
"I didn't have a chance in the first set,'' Li said. "But I looked at the clock and I saw it was only 20 minutes (into the match) so I told myself I could be winning in an hour. I knew I just had to hang in there.''
Li also beat the elder Williams sister, Venus, while reaching the semifinals at the Beijing Olympics. Venus Williams, who is still in the Stuttgart tournament, watched Serena's defeat Wednesday.
Ranked No. 30 in the world, Li wasted three match points at 5-3, then fell behind 0-40 in her next service game after Williams had held for 5-4. She then put in a service winner and followed with an ace. After successfully challenging a call that her serve was out to get it to deuce, she clinched the match with her third ace of the game.
Li missed 11 months with a rib fracture last year and right-knee surgery in March.
"I believe I can go into the top 10 if I stay healthy,'' she said.
Fourth-seeded Elena Dementieva, the Olympic gold medalist, advanced to the third round by beating Sybille Bammer 6-1, 6-4.
Earlier, another seeded player was upset when Victoria Azarenka beat No. 8 Agnieszka Radwanska 6-1, 7-5 to reach the third round.
Also, Patty Schnyder beat Svetlana Kuznetsova for the first time in more than three years and advanced to the second round of with a 6-4, 4-6, 7-5 victory over the fifth-seeded Russian on.
Schnyder now has a 3-5 record against Kuznetsova, whom she last beat at the German Open in Berlin in May 2005. Kuznetsova had won their last three matches.
"I played a great match, it was a real fight,'' the Swiss left-hander said. "There were lots of winners and break points. She defended the baseline very well, it was very tough.''
Schnyder broke serve for a 6-5 lead in the final set and clinched the win when Kuznetsova sent a backhand slightly wide.
The 11th-ranked Swiss is seeking her second title of the year after winning in Bali. Schnyder has 11 career titles.
Kuznetsova was coming off a runner-up finish at the China Open, her fifth final defeat of the year, with no titles in 2008. She was No. 2 in the world one year ago.
Seventh-seeded Vera Zvonareva also advanced to the second round by beating Daniela Hantuchova 6-3, 6-2.
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