William Hague has said the UK will recognise the Libyan rebel council as the "sole governmental authority", as Gaddafi-regime diplomats are expelled.
The Libyan charge d'affaires was called to the Foreign Office earlier to be told he and other diplomats must leave.
Instead the UK will ask the National Transitional Council to appoint a new diplomatic envoy.
It follows similar moves by the US and France. The UK previously said it recognised "countries not governments".
But Mr Hague said it was a "unique situation" and said recognising the NTC could help "legally in the unfreezing of some assets".
The green flag of the Gaddafi regime was still flying outside the embassy in Knightsbridge on Wednesday afternoon and attempts to reach staff for comment were not successful. Protesters carrying the red, green and black flag of the Libyan rebels gathered outside.
Libyan rebels and pro-Gaddafi forces are still locked in battle, five months after an uprising began against Muammar Gaddafi's 42-year rule, as Nato continues to enforce a UN-backed no-fly zone over the country.
At a press conference, Mr Hague said the NTC had shown its commitment to a "more open and democratic Libya... in stark contrast to Gaddafi whose brutality against the Libyan people has stripped him of all legitimacy".
He said a recent meeting of the Libya contact group in Istanbul had decided to treat the NTC as the legitimate government authority in Libya - and he was outlining the UK's response to that.
The UK would now deal with the NTC "on the same basis as other governments around the world" - and as a result the Libyan charge d'affaires had been summoned to the Foreign Office to be told all Gaddafi regime diplomats must now leave. It is thought that eight Libyan diplomats remain at the embassy.
"We no longer recognise them as the representatives of the Libyan government and we are inviting the National Transitional Council to appoint a new Libyan diplomatic envoy to take over the Libyan embassy in London," he said.
The change meant the UK could give "greater practical assistance than we've been able to give so far", he added.
The Foreign Office said the charge d'affaires, Khaled Benshaban, would be given three days to leave - while others would be decided on a "case-by-case basis".
Mr Hague said he was working with the NTC and Libyan banks and would do "all we can" to ensure Libyan students in the UK continue to receive the funds currently paid for by the Libyan embassy.
The foreign secretary also outlined measures to unfreeze assets worth £91m belonging to an oil company now controlled by the NTC to help meet "basic needs" in Libya.
More work will be done over the next few weeks to unfreeze more Libyan assets in the UK, including stocks of currency and other assets of the Libyan central bank.
Mr Hague was asked about the apparent change in tone from the UK government - in May it recognised the NTC as "the legitimate interlocutor in Libya" but Mr Hague said then: "This arrangement does not affect our position on the legal status of the NTC: the British government will continue to recognise states, not governments."
Asked on Wednesday if he had the backing of the attorney general - the government's chief law officer - for unfreezing Libyan assets, Mr Hague said the government "based on any legal considerations as well as political considerations are united in this position".
He said it was a "unique situation" but they were now dealing with the NTC "as if they were the state of Libya" adding: "It's not a fundamental change in our approach".
BBC deputy political editor James Landale said it was a political, not a legal statement which would allow the British government to unfreeze £91m assets from a Libyan oil company - but not the rest of Libyan assets frozen in the UK, which total about £12bn.
Libya's rebels have been saying for weeks that they need more money from the international community to pay for salaries and food supplies.
Mr Hague also said the appearance of Lockerbie bomber Abdelbaset al-Megrahi on Libyan TV, nearly two years after he was released by the Scottish government on compassionate grounds after being diagnosed with terminal cancer, was "a further reminder that a great mistake was made".
For Labour, shadow foreign secretary Douglas Alexander welcomed "the recognition of the progress" the rebel council had made adding: "It's right we continue to maximise the diplomatic pressure on the Gaddafi regime to help protect the Libyan people. As well as these moves we would also like to see more details and decisions taken on the important work of post conflict planning."
The UK embassy in Tripoli suspended operations in February but it has a diplomatic mission in rebel-held Benghazi. Libyan ambassador to the UK Omar Jelban was expelled in May.
This week Mr Hague suggested Col Gaddafi may not have to go into exile should he leave power - saying it was a "question for the Libyans".