Egyptian President Mohammed Mursi has said his move to order the retirement of two of the country's top generals was for "the benefit of this nation".
He was speaking after replacing the powerful head of the armed forces, Field Marshal Mohammed Hussein Tantawi, and the chief of staff, Gen Sami Annan.
Mr Mursi also issued a constitutional declaration giving him broad legislative and executive powers.
The generals assumed presidential powers after the fall of Hosni Mubarak.
Mr Mursi annulled a key constitutional declaration issued in June which gave the military legislative powers and budgetary controls as well as the right to oversee the process of drawing up a new permanent constitution.
It is not clear how the Supreme Constitutional Court will react to Mr Mursi's move to nullify the decree.
Meanwhile, the army has so far shown no sign of challenging the surprise replacement of Field Marshal Tantawi. State media quoted a military source as saying there was no "negative reaction" from within the armed forces.
In Cairo, thousands of people gathered overnight in Tahrir Square, expressing their support for Mr Mursi's move.
The BBC's Kim Ghattas in Washington says the US showed no sign of surprise at President Mursi's move.
US State Department spokeswoman Victoria Nuland said it was important that Egypt's civilian leadership and the military worked together "to advance the goals of the democratic transition in Egypt".
As the US gives more than $1bn in aid to the Egyptian military it would expect some degree of consultation or warning, our correspondent adds.
The new Egyptian defence team is made of up officials who have trained in the US and are known to the Pentagon, she says.
"The decisions I took today were not meant ever to target certain persons, nor did I intend to embarrass institutions, nor was my aim to narrow freedoms," Mr Mursi said late on Sunday during a speech to mark the Islamic holy month of Ramadan.
"I did not mean to send a negative message about anyone, but my aim was the benefit of this nation and its people," he said.
The president also praised the armed forces, saying they would now focus "on the holy mission of protecting the nation".
It was announced earlier that a career army officer, Gen Abdul Fattah al-Sisi, would replace Field Marshal Tantawi as both armed forces chief and defence minister.
Field Marshal Tantawi, 76, has not yet indicated whether he will accept the moves.
However, Gen Mohammed al-Assar, a member of the Supreme Council of the Armed Forces (Scaf), told the Reuters news agency the decision had been "based on consultation with the field marshal, and the rest of the military council".
A presidential spokesman said Gen Annan and Field Marshal Tantawi had been appointed as presidential advisers and were given Egypt's highest state honour, the Grand Collar of the Nile.
But it was not clear how far the generals, members of the Scaf, actually consented to a move that re-orders the country's political forces and gives Mr Mursi more powers while a new constitution is mooted, correspondents say.
"This clash between the new president and the military council was expected - but not this fast," analyst Gamal Soltan told Reuters.
"It can be considered a restructuring of the armed forces and an end to the role of Scaf in political life."
On Sunday, Mr Mursi also appointed Mahmoud Mekki as vice-president, a senior judge who fought for judicial independence under Hosni Mubarak.
BBC Middle East correspondent Kevin Connolly says the dismissal of senior military officers will be seen by Egyptians as a decisive move in a struggle for real power between the country's newly elected politicians and the generals who have exercised power for many years.
As head of Scaf, Field Marshal Tantawi became Egypt's interim ruler after President Mubarak was ousted following last year's mass protests.
Under the interim constitutional declaration issued by Scaf before Mr Mursi was sworn in, the president could not rule on matters related to the military - including appointing its leaders.
The council also dissolved parliament, which is dominated by the Muslim Brotherhood's Freedom and Justice Party (FJP).
Tensions between the presidency and Scaf were further exacerbated after Islamist militants in the Sinai peninsula killed 16 border guards last week, in a raid that embarrassed the military.
The president sacked Egypt's intelligence chief and two senior generals following the attack.
Mr Mursi resigned from his leadership positions within the Brotherhood, including his role as chairman of the FJP, when he won the presidential election in June.