The Knicks also waived swingman Dan Grunfeld, trimming their roster to 16 players.
Houston was forced to retire in October 2005 because of chronic knee pain, and has attempted a comeback in each of the last two preseasons. However, he was never able to get into a game this time because of a sore right quadriceps.
"It made it tough," Knicks coach Mike D'Antoni said. "And then a lot of times you've got to get breaks in our league in the sense of things had to open up and maybe something came out in some moves or whatever. Because nothing opened up, and then him not playing, just kind of couldn't do it at that point."
Still, the fourth-leading scorer in franchise history should stick around in some capacity working under team president Donnie Walsh.
"Although I was very excited about potentially joining my teammates in uniform, I believe that the circumstances suggest that I am best suited to serve the team in a different role," Houston said in a statement.
Grunfeld, whose father, Washington Wizards president Ernie, played for the Knicks and was their general manager from 1991-99, appeared in one preseason game.
The roster needs to be reduced to 15 by Monday's deadline.
- The Knicks picked up their contract options on guard Mardy Collins and forward Wilson Chandler.
- Rookie Danilo Gallinari, the No. 6 pick in the draft, scrimmaged for the first time Thursday. He had been sidelined since hurting his back in his summer league debut.
- Chandler, who sprained his left knee Tuesday against Boston, likely won't play Friday in the preseason finale against New Jersey.