The cut-off of the taxes collected since 1994 by Israel for the PA, used for most of the payroll for the authority's 130,000 employees, is expected to deal a major blow to the already-depressed Palestinian economy.
"One can assume the lifestyle of the Palestinians will change even though this is not the aim of the government," said the Israeli foreign minister, Tzipi Livni.
For now, the Israeli cabinet, under international pressure, has decided to refrain from banning the entry of the several thousand Gazans who work in Israel daily and starting a blockade on Palestinian exports - steps recommended by defence ministry officials.
Prime minister Ehud Olmert told ministers that the government inauguration ceremony in Ramallah and Gaza on Saturday - which capped Hamas's stunning victory in last month's parliamentary elections - marked a turning point in Israel's never cordial relations with the PA.
"With the swearing in and the designation of Hamas to form the new government, the Palestinian Authority has in fact turned into a terrorist authority," said Mr. Olmert. "Israel will not agree to this."
The PA was previously under the control of president Mahmoud Abbas's Fatah movement. Israel had shunned negotiations with the moderate Mr Abbas on the grounds that he did not move to dismantle armed groups.
Gaza Strip Hamas leader Ismail Haniye, whose selection as prime minister was announced by the movement yesterday, said Israel's decision "aims at bringing the Palestinians to their knees. These decisions don't frighten our Palestinian people or the coming Palestinian government. We've faced up to challenges in the past, and we can face up to future challenges."
Israel also called on the international community to withhold all aid to the Palestinian Authority, although it said humanitarian assistance to Palestinians should continue.
Israel "has no intention of harming the humanitarian needs of the Palestinian population" Mr Olmert said. But independent Israeli analysts say it will be impossible to damage the PA without also harming the civilian population.
"If you do not transfer money for the PA salaries, tens of thousands of families will go hungry because their source of income will be eliminated," wrote Amos Harel, military analyst for Haaretz newspaper. "And if you deny entry to thousands of workers from Gaza, their relatives who depend on them will suffer."
Israeli critics of the move say greater despair will simply increase public support for Hamas, which espouses Israel's destruction and has spearheaded suicide bombings against the Jewish state.
In advance of next month's elections in Israel, the hard-line Likud party is telling voters that only it knows how to handle Hamas. "We must make clear to the Palestinians that he who supports terror and tries to destroy us collectively will suffer collectively, " said Yuval Steinitz, the Likud chairman of the Knesset's Foreign Affairs Committee.
Over the last year, Hamas has largely observed a ceasefire orchestrated by Mr Abbas, contributing to a significant reduction of Israeli casualties. But despite international pressure it has ruled out recognising Israel.
Dov Weisglass, a senior adviser to Mr Olmert, who helped draw up the economic sanctions, was quoted last week as saying Palestinians "will feel as if they have been on a visit to a dietician. They will become thinner, but they won't starve to death."
Nabil Abu Rudeineh, a spokesman for Mr Abbas, called on the United States "not to let Israel carry out the sanctions."
Despite Hamas statements to the contrary, he insisted that the new government would follow the line of Mr Abbas, who said at the swearing in ceremony that peace negotiations with Israel are the "strategic choice" of the Palestinians, and added that resistance to occupation should be done through peaceful means.
Amr Moussa, the secretary of the Arab League, said yesterday that Arab governments were considering providing enough money to the PA to make up for the funds Israel plans to withhold.
Mr Abbas was expected to travel to Gaza yesterday for meetings with Hamas leaders on the formation of the government. Mr Haniye, 42, the former bureau director of Hamas founder Sheikh Ahmed Yassin, said he hoped to hold a dialogue with Mr Abbas to narrow differences.
Mr Haniye, married and a father of 11 children, has been responsible for Hamas relations with Fatah, and is considered a pragmatist.
In separate developments, four Palestinians were killed by Israeli troops yesterday during two separate incidents. Two Palestinians whom the army said were engaged in rocket firing were killed in southern Gaza in an airstrike. In Balata Refugee Camp, two teenagers were shot. Palestinians said the youths threw rocks at soldiers.