South Korean President Lee Myung-Bak also said North Korean merchant ships would be banned from using the South's shipping lanes, and confirmed that Seoul would refer the 26 March attack to the United Nations Security Council.
"From now on, Korea will not tolerate any provocative act by the North and will maintain the principle of proactive deterrence," he said in a nationally televised speech.
"If our territorial waters, airspace or territory are violated, we will immediately exercise our right of self-defence."
A multinational investigation team said last Thursday there was overwhelming evidence that a North Korean submarine fired a heavy torpedo to sink a 1,200-tonne corvette near the disputed border with the loss of 46 lives.
Numerous Western nations and Japan have condemned the attack, seen as one of the worst provocations since the end of the 1950-53 Korean War. But the North's ally China has called on all sides to show restraint.
The United States and China on Monday opened annual high-level strategic talks - with US Secretary of State Hillary Clinton urging Beijing to back the tough action against North Korea.
“Today we face another serious challenge provoked by the sinking of the South Korean ship - so we must work together to address this challenge and advance our shared objective of peace and stability on the Korean peninsula," Clinton said.
US President Barack Obama said sanctions against the North are "called for and entirely appropriate.
In suspending trade between the two sides, Lee exempted the jointly run Kaesong industrial estate just north of the border, and humanitarian aid for the North's children.
He vowed to speed up reform of his own military and strengthen its combat capabilities. He said that joint combat readiness between South Korean and US forces would be further strengthened.
US and South Korean will stage a joint anti-submarine exercise off the Korean peninsula in response to the sinking, Seoul's defence minister said Monday.
North Korea's military said it would open fire at any South Korean loudspeakers broadcasting propaganda across the border if Seoul follows through on its pledge to install them.
The South's Defence Minister Kim Tae-Young said the broadcasts, suspended since 2004, would be resumed in response to the warship’s sinking.