In a furious reaction to the report, a Yahoo spokeswoman said: "We were not aware of, nor would we condone, this reported activity.
"This report, if true, represents a whole new level of violation of our users' privacy that is completely unacceptable and we strongly call on the world's governments to reform surveillance law consistent with the principles we outlined in December.
"We are committed to preserving our users' trust and security and continue our efforts to expand encryption across all of our services."GCHQ declined to comment on the claims.
Files dated between 2008 and 2010 allegedly show a monitoring programme, known as "Optic Nerve", stored still images from Yahoo webcam chats and saved them to agency databases with the help of its US counterpart the National Security Agency.
GCHQ has consistently said its activities are necessary and "carried out in accordance with a strict legal and policy framework”.
Yahoo is set to make photo-sharing site Flickr "awesome" again, as the company revealed it has redesigned the website.
The news comes as Yahoo announced its $1.1 billion (£723m) takeover of blogging platform Tumblr.
Speaking at an event in New York City, Yahoo said it was now offering Flickr users one terabyte of online storage for free, enough to store more than 500,000 images at a resolution common to most smartphones.
The company also revealed the new website will emphasise photos rather than text or white space, creating bigger pictures, shared in full resolution.
US tech giant Yahoo has snapped up Tumblr in a major US deal that will reportedly net the blogging site's 26-year-old founder a 250 million US dollar (£164 million) fortune six years after he started it.
Per the agreement and our promise not to screw it up, Tumblr will be independently operated as a separate business. David Karp will remain CEO.
The purchase of Tumblr by Yahoo would add to established Internet companies like Google and Facebook that have spent $1 billion or more each buying startup companies in the battle for competitive edge in the technology business market.
Facebook last year paid cash and stock initially valued at about $1 billion to buy popular photo-sharing service Instagram, according to figures quoted in The Wall Street Journal.
Google paid $1.65 billion in stock seven years ago for YouTube, the online-video giant.
In a smaller deal, AOL bought Huffington Post for $315 million in 2011.