ISTANBUL—Prime Minister Recep Tayyip Erdogan suffered the worst blow in his decade in power when an old friend quit the cabinet and called for his resignation—the latest fallout from a corruption investigation that threatens to undermine the leadership of an important strategic partner for the West.

The public chastisement came after the premier pushed Environment and Urban Planning Minister Erdogan Bayraktar, who has served alongside Mr. Erdogan since the 1990s, and two other ministers to resign Wednesday. Each has a son who has been implicated in the graft investigation.

In a late-night news conference after an unscheduled meeting with President Abdullah Gul, Mr. Erdogan fired a fourth minister and announced a broad new cabinet lineup. He ignored the earlier parting shot from Mr. Bayraktar: "To soothe the nation, I believe that the prime minister should resign, too."

In response, the lira hit record lows against the dollar and the euro on Thursday, while yields on the country's benchmark two-year bond rose to a near three-month high.

The unusual upheaval in the governing Justice and Development Party, or AKP, underscores mounting challenges facing Mr. Erdogan ahead of a lengthy election cycle that starts in March.