Lundgren, testifying on Monday in the trial of two Macy's lawsuits over the alliance, said Stewart told him of the deal the night before J.C. Penney announced it. He said he was so appalled he hung up on her.
"I was completely shocked and blown away," Lundgren said. "I was literally sick to my stomach."
J.C. Penney announced on Dec. 7, 2011, that it would launch Martha Stewart boutiques in about 700 of its department stores in 2013. It also bought 17 percent of her company, Martha Stewart Living Omnimedia.
Macy's, which has its own deal with Martha Stewart, sued her company in January 2012 for breach of contract, and later sued J.C. Penney as well. Macy's says it has the exclusive right to sell Martha Stewart products in certain product categories, including cookware and bedding.
The two cases were consolidated for a non-jury trial before Justice Jeffrey Oing in New York state court in Manhattan.
Lundgren, 60, said Stewart sounded like she was reading from a document prepared by lawyers when they spoke, and that he cut off the conversation when the home goods doyenne claimed her deal with J.C. Penney would be good for Macy's.
"I think that's when I hung up," said Lundgren. "The thought this was going to be good for Macy's was so far from anything I could comprehend."
Lundgren said that at the time he considered Stewart a friend, and he has not spoken to her since.
Macy's is still committed to the business relationship it developed with Martha Stewart Living Omnimedia, however. The Martha Stewart brand at Macy's grew 8 percent last year, growth that is twice that of Macy's as a whole, Lundgren said.
"This is an extremely important brand and we are going to continue to highlight the brand in our stores," Lundgren testified.
Macy's built Martha Stewart into its No. 1 home brand after Stewart came out of prison in 2005 after serving time for lying about a stock sale.
J.C. Penney CEO Ron Johnson is scheduled to take the stand on Friday. Martha Stewart also is expected to testify, but it is unclear when.
Martha Stewart shops in J.C. Penney stores, set to open in May, are the centerpiece of an improved home goods section that Johnson has called crucial to returning Penney to growth.