C's answer above is what might be called the 'official' line, but...
It depends entirely on how you define the word �country'. Click
here where you will find two significant details - I won't call them 'facts', as I have no axe to grind either way. (The clickable links within that website are full of relevant information, including the criteria which define a country.)
One is that, strictly-speaking, the Vatican itself - which is almost invariably claimed to be the world's smallest - might not fully qualify as an independent �country'. The other is that the Knights of Malta's HQ - basically just a building in Rome - might equally claim to be a 'country' in some people's eyes.
There is even an old Royal Navy defensive fort seven or eight miles off the Essex coast at Felixstowe called �Sealand'. The British government and courts recently (reported in �The Times' of 6th December 2005) finally admitted that it is outside British national territory and not part of the United Kingdom. It, too, is now free to issue its own passports, currency and stamps, therefore, and its owners to claim it as a sovereign state.
Like beauty, it seems that what constitutes a country is often just "in the eye of the beholder" and, therefore, so is what constitutes the world's smallest.