First seen at E3 2009, the game would have seen players interacting with a child face-to-face using the Xbox 360's upcoming motion hardware.
The technology behind the title will now be used in a future Fable game with Kinect support, reports Kotaku.
Molyneux previously admitted that Microsoft was uncomfortable with the subject matter. Early footage from the game also inspired sardonic remarks from Guardian columnist Charlie Brooker, who joked that it made the player "look and feel like a paedophile".
Reports suggest that "a dozen" staff who worked on the project have been laid off.