Temporary factors like poor weather and disruption in the lead up to the Olympics also contributed to the slump in activity, which was expected to improve after June's fall due to the extra holiday, the Queen's Jubilee.
The seasonally adjusted purchasing managers' index for the service sector dropped to 51 from 51.3 in June, data from a Markit Economics survey and the Chartered Institute of Purchasing and Supply (CIPS) showed on Friday – economists had expected the index to rise to 51.6.
Service sector firms saw business increase in July and yet, were able to lower backlogs at the sharpest rate since November. Firms increased their workforces for the eighth month in a row.
With margins under pressure over strong market competition and weak demand, firm's discounting led to a fall in output charges.
Meanwhile, business sentiment among entrepreneurs remained positive as they expect to benefit from increased investment and new product releases, data showed.
UK's manufacturing sector contracted at the fastest rate since March 2009 on substantial declines in output and new orders, a Markit survey revealed. Gathering data from the manufacturing, construction and services PMI surveys, the All-Sector PMI dropped below 50.0 for the first time in 39 months in July, said Markit.
"The latest data further highlight the loss of momentum in the UK economy following the relatively bright start to the year," Markit Senior Economist Paul Smith said.
A preliminary estimate from the Office for National Statistics showed that the British economy continues to sink deeper into recession in Q2. Gross domestic product dropped 0.7%, marking the biggest fall since 1Q2009.
Inflation continued to slow in the UK on easing fuel prices amid weakening economic activity, down to 2.4% in June, the lowest since November 2009. The central bank estimates the inflation rate to be around 1.6% in two years time.