Human perception is significantly influenced by sensory context. A classic demonstration is the tilt illusion, in which the perceived orientation of a center stimulus is altered by the orientation of a surround (Gibson \& Radner 1937). Previous research on the tilt illusion has primarily focused on how surround context alters the response characteristics of individual neurons (e.g., changes in gain and tuning curves), but connecting these observations at the level of single neurons to perceptual behavior remains challenging. More broadly, we still lack a functional and teleological account of the tilt illusion. In this study, we present a comprehensive explanation at both the behavioral and neural levels within an efficient coding framework, showing that the illusion arises from changes in neural encoding precision induced by the surround context. We simultaneously obtained psychophysical and fMRI responses from human subjects while they viewed gratings in the absence and presence of an oriented surround, and extracted sensory encoding precision from their behavioral and neural data. Both measures show that in the absence of a surround, encoding reflects the natural scene statistics of orientation. However, in the presence of an oriented surround, encoding precision is significantly increased for stimuli similar to the surround orientation. This local change in encoding is necessary to accurately predict the behavioral characteristics of the tilt illusion using a Bayesian observer model. The effect of surround modulation increases along the ventral stream, and is localized to the portion of the visual cortex with receptive fields at the center-surround boundary. The pattern of change in coding accuracy reflects the surround-conditioned orientation statistics in natural scenes, but cannot be explained by local stimulus configuration. Our results suggest that the tilt illusion naturally emerges from a dynamic strategy that efficiently reallocates neural resources based on the stimulus context to maximize coding capacity.