Fears the escalating rhetoric could turn into open conflict on the divided Korean peninsula has weighed on investors in the South, Asia's fourth biggest economy.
The won fell more than two percent to an eight-month low in early trading, though it later recovered a little with traders seeing the rhetoric as falling well short of any threat of a military response.
"I solemnly urge the authorities of North Korea ... to apologise immediately to the Republic of Korea (South Korea) and the international community," President Lee Myung-bak said in a nationally televised address.
Late last week, a team of international investigators accused North Korea of torpedoing the Cheonan corvette in March, killing 46 sailors in one of the deadliest clashes between the two since the 1950-53 Korean War.
North Korea did not response immediately to Lee's speech. But just hours after he spoke, it issued a statement by its foreign ministry saying the country had the right to expand its nuclear deterrent.
It has long argued that it has been forced to develop atomic weapons in the face of what it says are threats to attack by South Korea and the United States.
"North Korea's goal is to instigate division and conflict," said Lee, speaking from the country's war memorial in the capital Seoul. "It is now time for the North Korean regime to change."
His government banned all trade, investment and visits with North Korea.
In what may alarm Pyongyang as much as anything, its wealthy neighbour said it also plans to reduce the number of workers in a joint factory park just inside the North which has long been an important source of income for the North Korean leadership.
Much of the diplomatic focus will be on China, the only major power to support North Korea and which earlier this month -- to the annoyance of the South -- hosted a rare overseas visit by the North's sickly looking leader Kim Jong-il.
U.S. Secretary of State Hillary Clinton, on a visit herself to Beijing, urged China to cooperate on the challenge posed by the sinking of the Cheonan.
The United States is pressing China to join international condemnation of North Korea.
Beijing has so far avoided joining in the blame of Pyongyang, saying it will make its own assessment of why the ship sank.
Analysts say Beijing is terrified of any action that might cause the already shaky North to collapse, sending chaos across into its territory and, perhaps even more worrying, leading to U.S. troops moving up the peninsula right to its border.
That means China is likely to be reluctant to support more sanctions against the North, whose economy is already in tatters.
TRADE ALREADY FALLING
A South Korean government report said the North's foreign sanctions-hit trade fell 10 percent last year and could fall further this year, forcing it to depend even more on China to prop up its economy.
Lee said the South reserved the right to defend itself if Pyongyang wages aggression. The North said much the same to its neighbour last week when it denied involvement in the sinking.
Local financial markets took some relief from Lee's comments which steered clear of any suggestion of military retaliation.
South Korean stocks and the won slightly cut losses while treasury bond futures extended gains as traders played down the chance the tensions with the North would develop enough to spark a massive capital flight.
"It's not that tensions with North Korea will be cleared up in one day but the speech was worded in such a way as to help reduce investors' jitters," said Yoon Yeo-sam, a fixed-income analyst at Daewoo Securities.
Kwak Joong-bo, a market analyst at Hana Daetoo Securities, echoed that view.
"South, North tension is certainly not positive, but given historical trends, losses that markets suffer over this will be brief, unless a drastic situation takes hold. By drastic, I mean war. I do not think war is likely though," he said.
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