The second-ranked Swiss star said earlier he didn't know what to expect when he played his first round-robin match in the season-ending event for the top eight players.
It turned out to be flashes of his usual brilliance, then a quick slide downhill. Federer faltered late in the second set with a rash of errors that allowed Simon to get back into the match.
Federer also lost his first match at last year's Masters Cup but went on to win the title.
The ninth-ranked Simon, added to the field when No. 1 Rafael Nadal withdrew with knee tendinitis, started finding the lines and capitalized on Federer's slip in play in the last two sets.
Simon ripped a backhand crosscourt winner on breakpoint as Federer served at 3-4 in the third set, then served his seventh ace on match point.
The crowd overwhelmingly favored Federer. Swiss flags were scattered around the nearly packed Qi Zhong stadium, and one section was a sea of red and white.
Federer appeared to take a few points to loosen up. Then, after wasting three breakpoints as Simon served at 1-1 in the first set, he broke through for a 3-2 edge, taking the game with a forehand that Simon couldn't touch.
Federer staved off a break point in the next game and finished off the set with a second-serve ace and seemed to be headed for a quick victory.
They traded early breaks in the second set, and Simon had a great chance to forge ahead but squandered three break points as Federer started to look tight while serving at 3-4.
Federer smacked a routine overhead and an easy forehand volley into the net to fall behind 0-30, then found the net again with a swinging forehand off a short ball at deuce, but managed to hold.
Federer wasn't as lucky in his next service game, with Simon breaking to take the set and level the match with a great backhand winner after a long rally.
Federer had to rally from 0-40 while serving at 2-3 in the deciding set, pumping his fist and shouting "Come on!'' Simon replicated the escape act in the next game, with Federer helping with two forehands that sailed way long. Simon got the deciding break in the next game.
Britain's Andy Murray faced American Andy Roddick in the late match.
Novak Djokovic and Nikolay Davydenko, who won their first matches in the Gold group, play each other Tuesday after Jo-Wilfried Tsonga and Juan Martin del Potro, both 0-1, face off.
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