The 28-year-old Hyundai driver, whose best performance to date is fifth in Sweden this year, ended the penultimate day in second place and two minutes and 13.6 seconds adrift of Volkswagen's double world champion.
On Friday, on the rutted stages in Sardinia, Paddon had become the first Kiwi to lead a round of the championship outside his home country.
He started Saturday with an 8.8 seconds advantage over Ogier but the Frenchman took the lead on the afternoon's 17th Monti di Ala' stage when Paddon spun and lost more than 10 seconds when the engine stopped.
Paddon then struck a rock on the next stage, with the car suffering a damaged transmission and forcing him to carry out roadside repairs.
"I don't want to be a drama queen but when it happened, it ripped my heart out," the New Zealander said of the incident.
"We hit a big rock on the driving line and I thought there was no way we could go on but we strapped it up as best we could."
Norwegian Mads Ostberg, in a Citroen, had threatened to take second place but suffered a puncture and ended the day -- the longest in the world championship since 2002 -- a minute and 12 seconds behind.
The rally finishes on Sunday after four more stages, including two identical loops north of Alghero.
Ogier has won three of the five rounds so far and has a 42 point lead in the championship over Norwegian Andreas Mikkelsen, who ripped a wheel off his Volkswagen Polo on a car-breaking Saturday and languished in 43rd place.
