Even as Hamas nominated one of its leaders, Ismail Haniya, to become Prime Minister, Israel accused the Palestinian Authority (PA) of becoming a "terrorist authority" and severed all links with the fledgeling administration.
Three weeks after Hamas won 74 of the 132 seats in the Palestinian parliament, Ehud Olmert, the acting Israeli Prime Minister, said: "The PA is, in practice, becoming a terrorist authority.
"Israel will not hold contacts with a Government in which Hamas takes part."
His cabinet agreed to cease the vital monthly funding of $50 million (£30 million).
But the Israeli Government, mindful of a US and European reaction, backed away from harsh restrictions urged by its military establishment that would have sealed off the Palestinians and thrown up an economic blockade.
Mr Haniya dismissed the Israeli decision to cut off funds used to pay the wages of the authority's 137,000 workers, saying that the tactic did "not scare the Palestinian people".
The head of the Arab League, Amr Moussa, said that Arab governments were considering providing money to bridge the gap left by the Israeli decision to withhold the funds — taxes from Palestinian workers and customs revenues from imported goods — due to be paid next at the beginning of March.
The Israeli Government urged international donors to stem the flow of money to the PA when Hamas took control. But officials said that Israel would not press for a halt to humanitarian aid so long as there were guarantees that it would not be used to finance violence.
Israel's security forces will step up checks at crossing points from the West Bank and Gaza and restrict the movement of Hamas officials in parts of the West Bank.
Tzipi Livni, the Foreign Minister of Israel, said that it was keen to distinguish between civilian and humanitarian cases and the PA, though she conceded it would make life harder for Palestinians. "One can assume that the lifestyle (of the Palestinians) will change, even though this is not the aim of the Government of Israel," she said.
The Palestinian President, Mahmoud Abbas, said that the decision would precipitate a "serious financial crisis" for the Palestinians. His spokesman, Nabil Abu Rudeineh, said that an already volatile society could be destabilised if the authority was unable to pay the wages of 58,000 security staff.
The President was to travel to Gaza last night to meet the Hamas leadership to ask it to form a government. Hamas has said that it hopes to do so by early next month.
But Mr Abbas and Hamas appear to be on a collision course after the President's tough speech at the swearing-in ceremony in Ramallah. He challenged the new government to honour peace agreements, including the Oslo accords that established the PA and recognised Israel, which is anathema to Hamas.
He emphasised the primacy of the Palestine Liberation Organisation, which had led the struggle against occupation for decades and would continue to be the people's sole representative in negotiations, apparently bypassing a Hamas-led government.
Mr Haniya said that Hamas leaders were prepared to discuss everything and hoped to form a national unity government, which the President's defeated Fatah party has rejected. "We want to avoid sharp debate, especially while the (Israeli) occupation refuses to recognise Palestinian rights," he said.