Egyptian state TV has said the country is recalling its ambassador to Israel until Israel explains why it reportedly shot dead five Egyptian policemen.
Demanding an apology, Egypt's cabinet was quoted as saying Cairo held Israel politically and legally responsible and was summoning the Israeli ambassador.
Israel says it will investigate the shooting, said to have happened as its forces pursued Palestinian militants.
The latest violence began on Thursday when gunmen attacked Israeli buses.
Eight people were killed in the attacks, near the Israeli Red Sea resort of Eilat.
Egyptian officials say Israeli forces chased the suspected militants across the border, and a number of people were killed - including the policemen.
Tensions between Israel and Egypt have escalated sharply, the BBC's Yolande Knell reports from Jerusalem.
Their 30-year-old peace treaty was already being tested after the long-time Egyptian leader, Hosni Mubarak, was forced from office earlier this year, our correspondent says.
'Erosion of order'
Hundreds of Egyptians protested outside the Israeli embassy in Cairo overnight, burning the Israeli flag and demanding that the Israeli ambassador be expelled from the country. Protests were reportedly continuing on Saturday morning.
"We don't want any ties with Israel," one protester, Ahmed Aggoura, told the BBC.
"Israel is only interested in a subservient Egypt, not a free Egypt. By protesting outside the embassy we're sending them a clear message. This is not Mubarak's Egypt anymore. If you kill our soldiers, there will be consequences."
On Friday, in Egypt's second city, Alexandria, a protester managed to take down the Israeli flag from the consulate there and replaced it with Egyptian and Palestinian flags.
After the initial Eilat attack, Israel expressed concern about security in the Sinai Peninsula and said Palestinian attackers had reached Eilat after entering Egypt from Gaza and travelling through the Sinai desert.
But, according to Egyptian state TV, the Egyptian cabinet issued a statement on Saturday denying it had lost control of the Sinai and demanding an apology from the Israeli leadership over "the sad and hasty remarks about Egypt".
"The cabinet assigns the Egyptian foreign minister to summon the Israeli ambassador in Cairo... in protest over shootings on the Israeli side of the border that led to deaths on the Egyptian side," the statement said.
Egypt's ambassador to Israel was being recalled, the cabinet said, "until we are notified about the results of an investigation by the Israeli authorities".
Cairo said it regarded the attack as a breach of the 1979 peace treaty between the two nations, and blamed Israel for lax border controls.
Under Mr Mubarak, ties between the two nations had been stable after a history of conflict.
But Mr Mubarak's ousting in a popular uprising has sparked fears among Israeli officials that a less amenable government could take charge in Cairo.
And correspondents say the Sinai desert region of Egypt has become increasingly lawless since Mr Mubarak was ousted, with a rise in militant activity inspired by al-Qaeda.
Speaking to the BBC's Today programme on Friday, Israeli government spokesman Mark Regev warned there had been an "erosion of law and order in some parts of Sinai in the last few weeks".
But he added: "Israel and Egypt have a common interest in the border remaining quiet and not allowing extremist elements to establish a platform in Sinai.
"I understand that the Egyptians have no interest whatsoever in once again extremist elements escalating violence along the border."
Since Thursday's attacks, Israeli aircraft have repeatedly attacked targets in the Gaza Strip, while Palestinian militants have fired more than 20 rockets into Israel.