Mikhail Elinsky, 42, also stabbed his niece - the dead girl's mother - resulting in serious abdominal injuries.
A video shows him repeatedly taunting officers with a knife and refusing to give himself up.
He was eventually shot by police and taken to a hospital in Astrakhan, Russia, where he later died.
The man's niece Tatiana had earlier pleaded with the authorities not to release him from psychiatric hospital, fearing he remained a danger after he had killed a woman six years ago.
She desperately tried to save her daughter Natalia but was was stabbed as she came close to the kitchen where Elinsky was butchering the child.
Eyewitness Anastasiya Miloserdova said:
"The little girl was his niece, and his mother had begged not to let him out of the mental clinic.
"And look how it ended - he ran around the area with the cut off head of the little one."
Tatiana said:
"We were about to go out, and my daughter was sitting on her tricycle.He pulled her off, grabbed her and took her to the kitchen.
"He closed the door and began to cut her.
"I tried to stop him and ran to the kitchen but he stabbed me in the stomach with his knife."
Her husband Igor (pictured above with the baby and below after the killing)was too grief-stricken to speak.
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