The South announced on Thursday that it had overwhelming evidence a North Korean submarine had entered its waters in March and attacked the Cheonan corvette, killing 46 sailors in what President Lee Myung-bak called a "military provocation".
North Korea denied the accusation and said it was ready to tear up all agreements with the South, with which it has technically been at war for more than half a century.
"It was a military provocation and violation of the U.N. Charter and the truce agreement," Lee, whose 2-½ years in office have seen relations with the North turn increasingly frosty, said in a statement.
"Since this case is very serious and has a grave importance, we cannot afford to have a slightest mistake and will be very prudent in all response measures we take," his office quoted him as telling a rare emergency National Security Council meeting.
Lee is expected to announce his response early next week.
Defense Minister Kim Tae-young said Seoul would work with the international community to come up with non-military sanctions against the reclusive state.
In the past, both sides had put a limit on their hostility.
"North Korea has surpassed these limits. For those acts, the government will definitely make sure North Korea pays," Kim said.
Yonhap news agency reported South Korea and the United States were considering raising the alert status on North Korea as tensions build.
"PHASE OF WAR"
North Korea was typically defiant.
"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 repeatedly said it would not strike back at the North, aware that would frighten away investors already jittery about the escalating tension on the divided peninsula.
Apart from international sanctions, 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 U.S. 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 now frail leader Kim Jong-il is pushed into a corner, the greater the risk of clashes. Kim is also trying to secure the succession for one of his sons.
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, U.S. Defense Secretary Robert Gates and spokesmen for the White House and the U.S. 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. U.S. Secretary of State Hillary Clinton is currently visiting the region.