Britain has ordered the immediate closure of the Iranian embassy in London and expelled all staff.
British Foreign Secretary William Hague also said the British Embassy in Tehran had been closed and all staff evacuated following an attack on the diplomatic mission yesterday.
A crowd broke through gates, ransacked offices and burned British flags in a protest over sanctions imposed by Britain on the Tehran government.
It was the most violent incident so far as relations between the two countries steadily deteriorate due to Iran's wider dispute with the West over its nuclear programme.
On top of its ban on British financial institutions dealing with Iran and its central bank last week, Britain has called for further measures and a diplomatic source said London would now support a ban on oil imports from Iran.
Mr Hague said Iranian ambassadors across the European Union had been summoned to receive strong protests over the incident.
But Britain stopped short of severing ties with Iran completely.
"The Iranian charge (d'affaires) in London is being informed now that we require the immediate closure of the Iranian embassy in London and that all Iranian diplomatic staff must leave the United Kingdom within the next 48 hours," Mr Hague told parliament.
It is the worst crisis between Britain and Iran since full diplomatic relations were restored in 1999, ten years after Ayatollah Ruhollah Khomeini's fatwa to kill author Salman Rushdie for his book "The Satanic Verses".
Mr Hague said it was "fanciful" to think the Iranian authorities could not have protected the British embassy, or that the assault could have taken place without "some degree of regime consent".
He said: "This does not amount to the severing of diplomatic relations in their entirety.
"It is action that reduces our relations with Iran to the lowest level consistent with the maintenance of diplomatic relations."
British Prime Minister David Cameron chaired meetings of the government's crisis committee last night and again this morning to decide London's response.
