Turkey is to expel the Israeli ambassador after details emerged of a UN report into last year's deadly raid on a Gaza-bound flotilla.
Officials in Ankara said it was also suspending all remaining military agreements with Israel.
Turkish Foreign Minister Ahmet Davutoglu said some of the report's findings, leaked to the New York Times, were unacceptable.
Turkey wants Israel to apologise for the raid but it has refused to do so.
Nine Turkish pro-Palestinian activists were killed when Israeli forces stormed the flotilla in May 2010.
The BBC's Jonathan Head, in Istanbul, says relations between Turkey and Israel have been frozen since last year's flotilla incident, but now they are being downgraded to the lowest possible level.
A leaked copy of the United Nations report says Israeli forces did use excessive force when they intercepted the Turkish-led flotilla trying to break Israel's blockade of Gaza.
But the report also concludes that Israel's naval blockade of Gaza is legal - a move that has angered Turkey.
Turkey announced the expulsion of the Israeli ambassador hours before the report was expected to be published.
Turkish President Abullah Gul said the report was "null and void for us", in televised remarks reported by AFP.
On Thursday Mr Davutoglu said the UN report was Israel's "deadline" to apologise.
Hamas, the militant group that runs the Gaza Strip, applauded the Turkish move.
"This is a natural response to the Israeli crime against the freedom flotilla," said spokesman Sami Abu Zuhri.
In the copy leaked to the New York Times, the report says: "Turkey and Israel should resume full diplomatic relations, repairing their relationship in the interests of stability in the Middle East and international peace and security".
Turkey recalled its ambassador to Israel shortly after the raid and cancelled joint military exercises.
"Turkey-Israel diplomatic relations have been reduced to a second secretary level," Mr Davutoglu told a news conference on Friday.
"All personnel above the second secretary level will return to their countries by Wednesday at the latest."
The publication of the UN report has been delayed several times to encourage reconciliation between Israel and Turkey, but that has not happened.
The report says: "Israel's decision to board the vessels with such substantial force at a great distance from the blockade zone and with no final warning immediately prior to the boarding was excessive and unreasonable."
But the UN panel of inquiry, chaired by former New Zealand prime minister Geoffrey Palmer, added that the naval blockade was legal and appropriate because it was aimed at preventing weapons being brought in by sea.
The New York Times says that while Israel feels vindicated by the report, Turkey is upset with the conclusion on the legal status of Israel's naval blockade.
Israeli commandos descended from helicopters on to the Turkish-owned Mavi Marmara in international waters about 130km (80 miles) from the Israeli coast.
Activists say the commandos started shooting as soon as they hit the deck but Israeli officials say they fired in self-defence.
Relations between Turkey and Israel, once close, have soured in recent years with Turkey's current Islamist government being more sympathetic than its predecessors to the Palestinian cause.
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