At issue is Panama's alignment with other Latin American countries as well as the European Union, Canada and the United States that have taken measures against President Nicolas Maduro's government on the grounds that he is undemocratically tightening his hold on power.
"Panama's government has decided to withdraw its ambassador to the Bolivarian Republic of Venezuela, Miguel Mejia, and asks the Venezuelan government to withdraw its ambassador accredited to Panama, Jorge Duran Centeno," the Panamanian foreign ministry said in a statement.
The communique came hours after Venezuela's government news agency AVN announced sanctions on Panama's president and other officials, and on a number of Panamanian companies including its main airline Copa.
Venezuelan aviation authorities also announced that all Copa flights "to and from the country are suspended as of April 6, 2018 as a measure to protect the Venezuelan financial system."
The Venezuelan announcements followed a declaration by Panama this week that it had added President Maduro to a list of individuals deemed a "high risk" in terms of money laundering.
Peru meanwhile told Maduro he is not welcome to attend a summit of leaders from across the Americas to be held in Lima next week.
That gathering will include US President Donald Trump, who has branded Maduro a "dictator" and taken steps to reduce Venezuela's access to international credit.
Venezuela is teetering on the brink of default despite sitting atop the biggest oil reserves in the world.
Hyperinflation, scarcities of basic food and medicine, and skyrocketing violence are gripping the country, prompting a swelling exodus of its citizens that is increasingly concerning the United Nations.
According to AVN, the sanctions against the Panamanian individuals and companies will result in a suspension "for 90 days (of) economic and financial relations."
In terms of Copa, that could signal significant problems for Venezuela itself.
Panama is the nearest major airline hub to Venezuela, and Copa is the main airline used by passengers in and out of Caracas. Departures from the Venezuelan capital are often booked up weeks or months in advance.
A succession of international airlines have in the past couple of years ended their flights to Venezuela, including Delta, United, Aerolineas Argentinas and Avianca.
The few left flying include Air France, Spain's Iberia, American Airlines and Swiftair from the US, Cubana and Turkish Airlines.
Humberto Figuera, head of the Airlines Association of Venezuela, old AFP ahead of the Copa suspension announcement that such a move would be "really serious."
"Copa has 35 weekly flights. Venezuela would find itself more isolated, as Copa is an airline with the most connections to destinations on the American continent," he said.
According to AVN, among the individuals singled out for the Venezuelan sanctions were Panamanian President Juan Carlos Varela, his vice president, Isabel de Saint Malo, and the minister for the presidency and the minister for the government.
The state news agency said Venezuelan prosecutors called for the sanctions were because of the alleged "recurrent use of the Panamanian financial system by Venezuelan nationals to move money and assets derived from crime against the nation's wealth."
- Countries: Latin America