North Korea said on Friday the peninsula was heading toward war and it was ready to tear up all agreements with the South, which has accused the North of torpedoing a navy ship near their disputed border.
South Korea said on Thursday it had overwhelming evidence that a North Korean submarine had entered its waters in March and attacked the Cheonan corvette, killing 46 sailors.
President Lee Myung-bak, whose 2-years in office have seen relations with the North turn increasingly frosty, was scheduled to hold a rare emergency National Security Council meeting to discuss how to respond in the wake of the findings on the sinking from an international team of investigators.
"From this time on, we will regard the situation as a phase of war and will be responding resolutely to all problems in North-South relations," the North's Committee for the Peaceful Reunification of the Fatherland said in a statement.
"If the South puppet group comes out with 'response' and 'retaliation', we will respond strongly with ruthless punishment including the total shutdown of North-South ties, abrogation of the North-South agreement on non-aggression and abolition of all North-South cooperation projects."
Seoul has previously made clear that it had no plans for a retaliatory strike, wary of the impact of a military conflict that would certainly hurt efforts to consolidate a recovery in Asia's fourth largest economy.
Fear of escalating tension weighed on South Korean financial markets on Thursday, already worried that investors jumpy about global financial concerns may pull out their money.
The South Korean won suffered its biggest daily fall against the dollar in 10 months. Stocks closed at their lowest in almost three months. South Korean financial markets were closed for a public holiday on Friday.
Instead of military action, South Korea has indicated that it would press the international community to take action, probably imposing more sanctions against the North.
There is little else it can do. Economic relations have come to a near standstill since Lee became president apart from a joint factory park just inside impoverished North Korea, which now has to rely almost entirely on China, its only major ally.
North Korea has frequently threatened to attack Seoul but analysts say that in the face of a much better equipped South Korean army, backed by some 28,000 US troops on the peninsula, any major confrontation would be suicidal for the Pyongyang leadership.
But there are some analysts who warn that the more the North's leader Kim Jong-il, trying to secure the succession for one of his sons, is pushed into a corner the greater the risk of clashes.
China has so far maintained its support of the North and said it would make its own assessment of the investigation into the sinking of the Cheonan.
North Korea said it would send its own investigators to the South to look into the incident. But Yonhap news agency quoted a South Korean defense ministry source as saying it had no intention of allowing such a delegation.
Mindful of the tension on the Korean peninsula, US Defense Secretary Robert Gates and spokesmen for the White House and the US State Department chose their words carefully in their responses to the report.
"Clearly this was a serious provocation by North Korea and there will definitely be consequences because of what North Korea has done," said State Department spokesman P.J. Crowley.
Gates said the United States was consulting with South Korea, which would decide what action to take.
US President Barack Obama's administration was talking to South Korea's neighbors and the UN Security Council on what to do next, White House spokesman Robert Gibbs said.
Japan said it would be difficult to resume nuclear disarmament talks between five regional powers and the North, and said Washington shared its view that such negotiations, aimed at aiding Pyongyang in return for a promise to drop its nuclear arms, were unthinkable.