Mr Erdogan's announcement followed a press conference on Friday in which Foreign Minister Ahmet Davutoglu said that Turkey would be downgrading its diplomatic representation in Israel to that of second secretary. On Monday, the Israeli embassy in Ankara was notified that all senior diplomats must leave the country.
The latest crisis comes after long months of negotiations between the two sides failed to reach an agreement on a form of apology or compensation for the deaths of the Turkish activists.
The report by the UN-appointed commission headed by former New Zealand Prime Minister Geoffrey Palmer, published after three delays on Friday, finally sealed the breakdown in talks.
While the report stated that Israel used "excessive" force in overtaking the Marmara and severely criticised the deaths, it also justified Israel's decision to impose a naval blockade on Gaza and questioned the motives of the Turkish government over the participation of the IHH Islamist movement in the flotilla. Turkey refuted the report's conclusions.
Both Prime Minister Benjamin Netanyahu, who decided against an outright apology to Turkey, and Defence Minister Ehud Barak, tried to downplay the implications of the crisis.
Meanwhile, senior Israeli officials said off the record this week that the latest statements simply affirmed a situation that has existed for almost three years.
"It was clear long ago that Erdogan had turned away from the strategic alliance with Israel, preferring warm relations with Syria and Iran," said one. "From the outset of Operation Cast Lead in Gaza, he was quite open about it and the Marmara incident simply put the seal on it."
Another senior source said: "Turkey has more to lose through its relationship with the Americans and the withdrawal of Israeli military aid."
Prime Minister Netanyahu said on Sunday: "I hope a way will be found to overcome the difficulty with Turkey, we are not interested in ruining relations." This muted response belies the fact that despite earlier disagreements within the Israeli cabinet about an apology to Ankara, there is now a near-consensus that the conflict was not avoidable. "We were in favour of reaching some kind of compromise," said an adviser to one of the senior ministers who had opposed Foreign Minister Avigdor Lieberman's position that Israel should not apologise in any way, "but it is clear now that Erdogan, for his own reasons, was not going to settle for anything besides Israel's humiliation and we could not have agreed to that."
Turkey has already taken delivery of ten advanced Israeli unmanned aerial vehicles (UAVs) and 170 M60 tanks refurbished by Israeli defence companies, but the maintenance of these will suffer without Israeli advisers.
Israel has already lost many of its allies in the Turkish armed forces following the arrests and resignations of dozens of senior Turkish generals in recent months. The Israeli air force has stopped its joint exercises in Turkish airspace but has stepped up co-operation with other European nations such as Greece, Italy and Romania.
Israel signed a security co-operation pact with Greece on Sunday although a defence spokesman said that the agreement was initiated last year and has nothing to with the current crisis with Turkey.
The Israeli defence establishment believes that the Turkish navy, despite Erdogan's statement, will avoid confrontation with Israeli ships.
One immediate worry, though, is the increased backing that Turkey plans to give to the Palestinian bid for recognition of an independent state at the UN General Assembly later this month.
This could make it more difficult for the US to arrange a compromise and avoid another diplomatic setback. Turkey's belligerent stance may also force other governments in the region, such as the military regime in Egypt, to bow to public opinion and adopt an even tougher stance towards Israel.
Turkish security services on Monday morning apprehended and searched all Israeli passport-holders on the morning flight to Istanbul and questioned them for over an hour before releasing them. The Foreign Ministry believes this was a local and mid-level initiative, however.
Turkish Jews uneasy but unharmed
Turkish Jews deeply deplore the deterioration of the relations between Israel and Turkey, but do not seem worried about the possible impact on their lives – for the time being.
"Nothing has changed and hopefully will not change as far as the situation of the Jews here is concerned," said the president of the Jewish community, Sami Herman. "The crisis is in no way affecting our daily lives or the attitude of the Muslim population towards us."
However, a businessman said, on condition of anonymity: "The Jews still feel uneasy about the crisis. Today it's business as usual for us. But tomorrow we don't know what could happen."
There has been no sign of any antisemitic attacks, although anti-Israeli sentiment has been rising.
Foreign Minister Ahmet Davutoglu stressed in a statement that the sanctions were addressed to the Israeli government, "but not to the Israeli or Jewish people".
The Turkish media, including major TV channels, have warned against a rise in antisemitism. An article in leading daily Milliyet said "We must be sensitive about antisemitism at a time when tension is high with Israel... If we tend to believe in conspiracy theories and see the Jews behind every negative event, we'll be completely cut off from reality."
Meanwhile, there have been reports in the Israeli and Turkish media that Uefa is considering switching Maccabi Tel Aviv's match in Istanbul on September 15 against Besiktas in the opening round of the Europa League Group Stage to a neutral venue.
Maccabi spokesman Ofer Ronen-Abels said that such reports were "media speculation" and that his club had no security worries. Tel Aviv travel agents expect hundreds of Maccabi fans to snap up special package tours to the game.
It is understood that Uefa is, however, closely monitoring the situation and has contingency plans to move the match away from Istanbul.
by Sami Kohen in Istanbul and Simon Griver in Tel Aviv
