Needing a victory to have any chance of reaching the quarter-finals, we got off to the perfect start when Alfie Harrison fired us into an early lead.
But the Potters hit back with two goals in a minute in the first half from Jake Griffin and Nathan Lowe to leave us trailing at the break.
City went close to pulling the game back with Michael Okeke striking the woodwork but Lowe added a second for the visitors.
After beating Blackburn Rovers Under-17s 6-0 in the previous game following a narrow 4-3 defeat to Manchester United in the opening group match, reaching the last eight remained a possibility.
And City started strongly, going close inside five minutes when Jaden Heskey seized on an underhit backpass, taking it around the keeper before flashing an effort across goal.
A deserved breakthrough finally came in the 17th minute with a well-worked work move started in the backline by Jacob Wright who won a 50-50 challenge before casually spraying a long pass into the path of Lawrence. The winger picked out Harrison at the backpost and the midfielder, who scored a hat-trick against Blackburn earlier in the competition, finished neatly.
But with City seemingly in control, the game turned on its head when Stoke struck twice in the space of 60 seconds.
Centre-back Griffin headed the Potters level when he rose the highest from a deep corner before Lowe fired the visitors ahead. City keeper George Murray-Jones made two smart saves from close range before Lowe finally swept home at the third attempt.
The quick double rocked City and Lowe went close to a second before we re-established control of the game with Ashton Muir going close to an equaliser following a driving run from Okeke.
Lowe was a constant threat on the break, and he forced another good save from Murray-Jones before he beat the City keeper after racing clear again.
City kept pushing and came close to puling a goal back when Okeke found space in the box but his low shot smacked against the foot of the post and Stoke saw out the victory.
HOW WE LINED UP
Manchester City Under-17s
Starting XI: Murray-Jones, Carrington, Wright, Samuel (Dada-Mascoll 46), Naylor (Oboavwoduo 78), Whittingham, Lawrence (Ndala 46), Okeke, Heskey, Harrison, Muir (Alfa-Ruprecht 79).
Stoke City Under-17s
Starting XI: Houston, Challinor, Asplin-Rowley, Smith, Griffin, Bickerton, Maskell, Sidibe, Lowe, Watson (Agina 25), Hayder (Togo 75).
Subs: Brammer, Rattray, Gardner.
WHAT IT MEANS
Unfortunately, it means the defence of our trophy ends at the group stage with only the top side plus the best runner-up from seven groups progressing to the quarter-finals.
Our Under-18 side are back in action on Saturday with a top-of-the-table clash away to Sunderland.
The Black Cats are top of Premier League North with 19 points from eight games but City can overtake them with a win and you can watch the game live on CITY+ & Recast.