Ofcom has levied the fine on Key 103, owned by Emap, after complaints about late-night phone-ins hosted by James Stannage during October and November last year.
The six complaints surrounded comments and jokes about the death of Ken Bigley, who was beheaded in Iraq in October last year by terrorist leader Abu Musab al- Zarqawi. The jokes concerned the manner of his death and references to his wife being from Thailand.
Other incidents giving rise to complaints included Stannage making abusive comments about Muslims and using a mock Asian accent; making stereotypical comments about arranged marriages; and criticising a celebrity partly on the basis of her religion.
The radio station did not attempt to defend Stannage's comments, admitting that they had crossed a line into an are that was "totally unacceptable".
Gus Mackenzie, managing director of Key 103 FM, said: "We completely accept the Ofcom findings and have apologised wholeheartedly. James Stannage no longer works at Key 103, his contract having been terminated."
Ofcom criticised Key 103 for a failure to put in more robust controls on its output, and for not having an effective system of monitoring output. It said that steps taken to rectify the situation after previous incidents were "clearly in adequate".
"It had relied too heavily on the presenter's personal assurances that such content would not be repeated when it should have been clear to them that serious breaches were likely to occur again," the watchdog said in its ruling.
Stannage has previously caused the station to be fined, in 1996 and 1997. He also was found in breach of the programme code in 2003 for comments made during a discussion with a Lupus sufferer, where he told the caller how she should have carried out her suicide attempt.
Along with the £125,000 fine, Key 103 will have to transmit Ofcom's statement of finding three times a day over a week.
The comedian Billy Connolly was widely criticised at the time for allegedly joking about Bigley while he was still being held captive.
The Spectator also found itself at the centre of a media storm, after it wrote an editorial accusing Liverpudlians of wallowing in grief following Bigley's murder. Editor Boris Johnson made a humiliating visit to the city to apologise.
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