Wang, the world No 34 and 10th seed at the grand slam warm-up event, had won the opening set in 47 minutes but the unseeded 25-year-old Italian came back to win the next set 7-5 despite being 5-2 down.
The 29-year-old looked tired as she misplaced several shots in a decisive third set, including hitting a forehand into the net to give up a break point at 3-3.
China’s No 1 rallied by holding her serve to love to make it 5-4 but Paolini then served for the match, and despite forcing an error and winning the next point, the Italian saw it out.
Wang hit a long forehand to seal the match for Paolini after two hours and 21 minutes.
She missed the US Open and Cincinnati Masters last year, citing Covid-19 concerns. She also ended her partnership with coach Thomas Drouet for the same reason. It is almost a year since her last singles win at the Hua Hin Championships last February.
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Wang is in action in the doubles later on Monday with Romanian partner Irina Camelia Begu against Russia’s Vera Zvonareva and Germany’s Laura Siegemund.
Her best Australian Open finish came in reaching the fourth round last year, beating Serena Williams in the third round. She reached a career best singles quarter-finals at Wimbledon the year before.