Welshman Williams, 24, was withdrawn from the fight by his corner at the start of the 10th round with blood pouring from a severe cut to his eye.
Williams had seemed in control of the contest and was one point ahead on all of the judges' scorecards.
It was unclear whether the cut occurred because of a clash of heads or following a punch.
Liverpudlian Smith, however, was declared the winner and spoke of his disappointment after the fight following his failure to make the weight before the bout.
It means the 28-year-old was not able to be crowned as the WBO's interim world light-middleweight champion.
Gary Lockett, who trains Williams, told BBC Wales Sport he felt he had "no option" other than to pull his fighter out.
"The eye was damaged, it was a decision that had to be made," he explained.
"He said he couldn't see. I can't let him fight with that. It was only going to get worse. He couldn't see out of it."
It later emerged that Williams had suffered a severe double laceration to his right eyelid and was immediately sent to see a plastic surgeon.
Smith believes it was a fist, not a head, that did the damage, and both he and promoter Frank Warren made clear a rematch could well be set.
"It's a shame the winner is not coming away with a title. We'll try and do it again for a title," Warren said.
Smith added: "I am the most genuine fighter you'll come across, if Frank (Warren) offers the money I would do that again."
Williams made a tremendous start to the contest, culminating in a vicious right hand that cut Smith above the right eye.
However, the Liverpool fighter was getting back into things in a tremendously entertaining fight before the decision at the start of round number 10.
Liam Smith beat domestic rival Liam Williams in controversial fashion at the Manchester Arena.