Saudi Arabia is reportedly stopping all flights to and from Iran - and banning its citizens from travelling there.
Saudi foreign minister Adel al Jubeir told Reuters all commercial ties between the countries would also be cut.
It follows attacks on the Saudi embassy in Iran by protesters angry at the execution of Shia cleric Sheikh Nimr al Nimr.
Sunni-led Saudi Arabia claims the killing was part of a war on terrorism - but it has sparked protests among Shia Muslims throughout the region.
In response to attacks on its diplomatic missions, Saudi has ordered all Iranian diplomats to leave the country within 48 hours.
The foreign minister blamed "Iran's aggressive policies" over many years.
Sunni allies Bahrain, Sudan and United Arab Emirates have also severed or reduced diplomatic ties with Iran.
Their intervention represents another escalation in tension between the two branches of Islam.
Iran, a Shia powerhouse, has accused Saudi Arabia of using the attacks on its embassy in Tehran to deliberately stoke "tensions" in the region.
"Saudi Arabia, which thrives on tensions, has used this incident as an excuse to fuel the tensions," foreign ministry spokesman Hossein Jaberi Ansari said in televised remarks.
No Saudi diplomats were in the embassy at the time and all have now been called home.
Iranian officials condemned the attack, as well as Sheikh al Nimr's execution by Saudi Arabia.
The 56-year-old was a driving force behind anti-government protests in Saudi during the Arab Spring of 2011.
He was put to death along with 46 other prisoners on Saturday.
Iran's supreme leader said Saudi politicians will face "divine vengeance" for killing the cleric.
There has also been sectarian anger in eastern parts of Saudi, with hundreds of Shia Muslims marching through the streets, and demonstrations spread to countries including Turkey, Pakistan, India and Lebanon.
Police fired tear gas at demonstrators in Bahrain, while two Sunni mosques were bombed in Iraq's Hilla province.
ome 5,000 Shia demonstrators amassed near the foreign ministry in Baghdad on Monday calling for Iraq to sever all ties to Saudi Arabia.
China declared itself "highly concerned" with the developments, while Germany and the US called for calm.
An unnamed diplomat quoted by Russian state media said Moscow was ready to act as a peacemaker between the two countries.
The Arab League said it would hold emergency talks at the request of Saudi Arabia.
There had been concerns that Iranians would be barred from making pilgrimages to Saudi Arabia amid the tensions, but the foreign minister confirmed this would not be the case.
Source skynews
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