United had fought back from two goals down, thanks to two strikes from Steve Torpey, but a defensive error by centre-back Cliff Byrne allowed Lee Steele to score a dramatic 88th minute winner to sink Scunthorpe at the Kassam Stadium.
Steele, introduced as a substitute with 25 minutes to go, took full advantage of a mistake by Byrne with just two minutes remaining to coolly shoot home left footed past the despairing dive of Tom Evans.
The match had dramatically worsened in the second half, after the two teams produced a scintillating opening period.
Oxford, looking to move six points clear of the fourth-placed team in the table, shocked the visitors by switching from their tried and trusted 5-3-2 formation, playing three men up front.
The switch almost paid off inside the opening ten minutes, when Mark Rawle, making his first start for four months, latched onto a James Hunt header, only to smash his shot over the bar with just Evans to beat.
On the half-hour mark, the home side did go in front when a free-kick from Matt Robinson was flicked past Evans and into the net by Paul Wanless.
Four minutes later, Rawle doubled the advantage when his vicious left-foot shot found the net via the inside of a post.
But the visitors hit straight back with Steve Torpey shooting home from eight yards after Cleveland Taylor had seen a rasping drive come back off the bar.
And with just a minute remaining in the opening period, Torpey put Scunthorpe back on level terms when heading home a free-kick from 12 yards out.
Oxford striker Steve Basham wasted a golden opportunity to restore his side's lead in first-half injury time, blazing wide when well placed.
And after a dire second half, the home faithful were sent home happy when Steele capitalised on Byrne's slip to open the gap between themselves and the chasing pack.