SEOUL (Reuters) - North Korea said on Tuesday it was cutting all ties with the South and threatened its wealthy neighbor with military action over alleged violations of its waters off the west coast.

The comments marked a new high in tensions on the divided peninsula after the March sinking of a South Korean warship, which Seoul blames on a torpedo fired by the communist North.

The increasingly war-like rhetoric hit Seoul’s financial markets, prompting policymakers to call an emergency meeting on Wednesday to look for ways to calm investors.

“The Committee for the Peaceful Reunification of Korea .... formally declares that from now on it will put into force the resolute measures to totally freeze the inter-Korean relations, totally abrogate the agreement on non-aggression between the north and the south and completely halt the inter-Korean cooperation,” the North’s KCNA news agency reported.

North Korea will also expel personnel from the Kaesong industrial park, a joint North-South venture just inside its border. It was not immediately clear what impact that would have on factories there.

The industrial estate, in which South Korean firms employ cheap North Korean labor, is an important source of revenue for the Pyongyang leadership.

North Korea earlier said if the South continued to cross into its side of the disputed sea border -- the scene of deadly clashes in the past -- the North would “put into force practical military measures to defend its waters.”

The North referred to the South’s government as “military gangsters, seized by fever for a war”.

A report by international investigators last week accused the communist North, already under international pressure over its nuclear program, of torpedoing the Cheonan corvette in March, killing 46 sailors.

On Monday, South Korean President Lee Myung-bak cut trade with his impoverished neighbor and blocked its commercial ships from sailing through the South’s waters.

He also plans to take the issue to the U.N. Security Council. U.S. Secretary of State Hillary Clinton said in China on Tuesday that Washington and Beijing would work together to come up with an “effective, appropriate” response to the sinking, which Washington condemned.

Clinton said both sides should examine the issue over time, suggesting quick Security Council action was unlikely.

“(China) shares with us the goal of a denuclearised Korean Peninsula and a period of careful consideration in order to determine the best way forward in dealing with North Korea.”

In Washington, State Department spokesman P.J. Crowley called Pyongyang’s approach “odd.” “I can’t imagine a step that is less in the long term interest of the North Korean people than cutting off further ties with South Korea,” he said.

RUSSIA SEEKS RESTRAINT

Russia, which like China and the United States holds a veto in the Security Council, urged restraint.

China, the North’s only major ally and which effectively bankrolls its economy, has studiously tried to keep out of the fray, urging calm and refusing to voice support for the international report on the Cheonan sinking.

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It means that South Korea has almost no chance of winning further U.N. sanctions against its neighbor.

The issue is certain to dominate talks in Seoul on Wednesday with Clinton, who was arriving after talks in Beijing.

Most analysts doubt either side would risk a war, which would be suicidal for the North and economy-ruining for the South.

Seoul’s key economic and financial authorities will meet early on Wednesday to discuss ways to stabilize local financial markets.

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Some in the market saw the selling -- which took stocks on the main index to their lowest close in 15 weeks -- as overdone and triggered mostly by foreign selling.

“North Korea and related risks have always been there. It is like telling investors to quit the Japanese market because it has earthquakes. War is wanted neither by the North nor the South,” one fund manager at a foreign investment management house said.

FURIOUS RHETORIC

Both sides have stepped up their rhetoric over the Cheonan incident, one of their deadliest since the 1950-53 Korean War.

The North accused South Korea’s government of fabricating the issue, partly to help the ruling party in next week’s local elections -- important to cement President Lee’s power in the second half of his single five-year term.

The incident appears to have done nothing to dent Lee’s popularity, which one recent opinion poll shows running at well over 40 percent, unusually high for recent South Korean presidents halfway through their term.

A strong showing for Lee’s party in the June 2 local election, which many expect, will give him greater authority to push aside a fragmented opposition in parliament and continue with sweeping pro-business reforms.

His rule has also seen relations with the North turn increasingly chilly as he turned his back on a decade of generous aid to the North by his predecessors which had failed to end its attempts to build nuclear weapons.

Some worry pushing North Korean leader Kim Jong-il too far may leave him little choice but to fight back to try to save his family’s more than 60-year hold over the destitute country as he tries to secure the succession for his youngest son.

Analysts say the main risk is that small skirmishes along the heavily armed border could turn into broader conflict.