South Korea is to strengthen its military force on five islands close to North Korea, amid tensions over a clash that left four people dead.
It will also review military policy on the use of force, amid concerns it had become "rather passive".
Its defence minister has resigned amid criticism of the response.
North Korean shelling of a South Korean island on Tuesday killed two civilians and two marines, and prompted an increase in regional tension.
China, which has not apportioned blame, urged both sides to show "restraint".
North Korea, meanwhile, has threatened further military action if South Korea continues on what it called a "path of military provocation", the North's official KCNA news agency reported.
Pyongyang has blamed Seoul for this week's incident on Yeonpyeong island. The South was holding military exercises in the area at the time, and returned artillery fire following the North Korean shelling.
The North also accused the United States of stoking tensions - saying the US helped draw up the "illegal" western maritime border between the two Koreas.
About 28,000 US forces are stationed in South Korea.
The clash was one of the worst incidents between the two Koreas, who remain technically at war following the 1950-53 Korean War.
The shelling set alight numerous houses on a South Korean island very close to the disputed western maritime border, killed four people and injured several more.
After holding an emergency cabinet meeting, South Korea announced it would dramatically increase its military capability in the area.
"[The government] has decided to sharply increase military force, including ground troops, on the five islands in the Yellow Sea and allocate more of its budget towards dealing with North Korea's asymmetrical threats," the presidential senior public affairs secretary, Hong Sang-pyo, told reporters.
He said the government had also decided to make new rules of engagement "to change the paradigm itself of responding to North Korea's provocation", describing the current rules as "rather passive".
The BBC's Chris Hogg says the cabinet had decided that in the existing rules of engagement there was too much emphasis on preventing a military incident escalating into something worse.
There is now an awareness that this thinking had to change, our correspondent says.
In future the South would implement different levels of response depending on whether the North Koreans attacked the military in the South or civilian targets, the spokesman said.
Defence Minister Kim Tae-young - who faced a tough grilling by lawmakers on Wednesday over the incident - resigned hours after the meeting, government officials said.
The US and South Korea are to hold joint naval exercises in the coming days south of Yeonpyeong island.
A foreign ministry spokesman in Seoul said the decision had been made during a phone conversation between US Secretary of State Hillary Clinton and South Korean Foreign Minister Kim Sung-hwan on Thursday.
"We agreed that through the drill, we will be able to send a clear message to the North," the spokesman said.
The Chinese foreign ministry expressed "concern" over the exercises. "We oppose any act that undermines peace and stability on the peninsula," it said.
Beijing, Pyongyang's main ally, has been under pressure to use its influence over the North to ease tensions.
Earlier Chinese Premier Wen Jiabao, who is in Moscow, described the situation on the peninsula as "grim and complicated".
"Relevant sides should maintain the utmost restraint and the global community should do more to relax the tense situation," he said.
Mr Wen repeated his view that six-nation talks on the North's nuclear programme should be resumed as soon as possible, a position shared by North Korea.
South Korea, the US and Japan have said the six-nation talks should not restart until the North stops uranium enrichment work and apologises for its alleged torpedoing of a South Korean warship in March, at the cost of 46 lives.
A visit by Chinese Foreign Minister Yang Jiechi to South Korea, which had been due on Friday, has also been postponed. The delay was put down to "scheduling" issues.