Turkey has expelled Israel's ambassador to Ankara and suspended all military agreements with Israel following the leaked release of a report on a lethal Israeli raid last year.
Nine Turkish activists died in the raid on a six-ship aid flotilla trying to break Israel's naval blockade of Gaza, and Turkey has been demanding an apology.
Israel has refused to apologise, saying its troops acted in self-defence.
The report of a United Nations inquiry chaired by former New Zealand Prime Minister Geoffrey Palmer has been leaked to the New York Times.
It says Israeli commandos used unreasonable force in the raid but confirms Israel's view that its naval blockade of Gaza is lawful and a "legitimate security measure" to stop weapons reaching Palestinian militants by sea.
An Israeli inquiry reached the same conclusion, while a Turkish one found it to be unlawful and a collective punishment of the people of Gaza.
Report seen as rare vindication
The Palmer report has been seen by the media in Israel as a rare vindication by the UN.
The dilemma that remains for Israeli officials, the BBC reports, is how to handle the deepening of the rift with Turkey, a long-time regional ally with which Israel has trade, military and strategic ties.
This report was meant to mend relations but has achieved just the opposite.
Turkey wants an apology and compensation for the families of the victims. Israel has expressed only regret but may consider payouts. It believes a full apology would demoralise its citizens and project weakness.
Troops met 'violent resistance'
After the raid in May 2010, the Israeli military said its commandos fired live rounds only after being attacked with clubs, knives and guns. But activists on board said the commandos started shooting as soon as they hit the deck.
The Palmer report has found the Israeli troops faced "significant, organised and violent resistance from a group of passengers" and were therefore required to use force for their own protection.
But it also says Israel's decision to board the vessels "with such substantial force at a great distance from the blockade zone and with no final warning immediately prior to the boarding was excessive and unreasonable".
The report noted "forensic evidence showing that most of the deceased were shot multiple times, including in the back, or at close range".
Israel must pay, says minister
The report was completed months ago, but its publication was delayed several times as Turkey and Israel tried to repair their diplomatic relations, which have been frozen since the flotilla incident.
But on Friday, hours before the report was expected to be released, Turkey announced that diplomatic relations had been reduced to the level of second secretary and all military agreements had been suspended.
Turkish Foreign Minister Ahmet Davutoglu said: "The time has come for Israel to pay for its stance that sees it above international laws and disregards human conscience.
"The first and foremost result is that Israel is going to be devoid of Turkey's friendship."
Turkey does not recognise Israel's blockade of Gaza.
Mending of relations sought
An Israeli official says Israel's government accepts with "reservations" the UN report, which it considers "professional, profound and serious".
The official says the soldiers who boarded the boat had no intention of hurting anyone, but once they were attacked by dozens of activists "armed with batons, knives and steel pipes", they had to defend themselves.
Israel says it will work to mend relations with Turkey. It says it has made many unsuccessful attempts in recent months to settle the dispute between the two countries.