Egypt´s state-run gas company has terminated a controversial natural gas deal with Israel, adding stress to the increasingly fragile relationship between Israel and one of its only diplomatic partners in the Arab world.

If upheld by Egypt´s military rulers, annulling the gas deal would level a symbolic blow to peaceful ties that have underpinned regional stability for more than three decades. Israel has said that the cancellation of the gas deal puts Egypt in violation of an economic annex of their 1979 treaty—the first between Israel and an Arab state.

The full impact of the decision was difficult to determine on Sunday night, and Israeli foreign ministry officials said they were still seeking clarification from Egyptian counterparts because they had not been formally notified.

With only two months before Egypt´s military authorities are set to turn over power to one of the first popularly elected presidents in Egyptian history, the decision could augur the beginning of a steady worsening in relations.

Israel´s Finance Minister Yuval Steinitz said his country viewed the cancellation of the agreement "with great concern."

"This is a dangerous precedent that clouds the peace agreement between Israel and Egypt," Mr. Steinitz said in a statement.

Sunday´s cancellation appeared to be a business gambit aimed at securing a higher price and it remained unclear on Sunday night whether Egypt´s interim ruling military leaders would intervene, said business analysts. The council of generals could not be reached for comment and they did not issue a statement on the matter.

Ampal-American Israel AMPL -3.70% Corporation—a stakeholder in the pipeline joint venture, which transmits the gas between the countries— reported on its website Sunday that two of Egypt´s state-owned natural gas companies had severed the gas export contract. Ampal said the Egyptian decision was "unlawful and in bad faith." The move ends an export deal that had helped buttress Egypt´s nearly 33-year-old peace treaty with Israel since it was signed in 2005.

The head of the state-owned Egyptian Natural Gas Holding Company, or EGAS, Mohamed Shoeb, said Sunday evening that his company ended the deal last Thursday for purely commercial reasons. "It is a commercial contract between companies," Mr. Shoeb said.

He said East-Mediterranean Gas, the Israeli-Egyptian firm that buys gas from the Egyptian state and sells it to Israel, has failed to pay for the past several months—a claim that Israeli Foreign Ministry spokesman Yigal Palmor denied, according to news reports. Ampal owns a 12.5% stake in EMG.

The decision will not cause any serious economic damage for either country, but it will likely pay huge political dividends for Egypt´s embattled interim ruling military regime and its civilian-appointed cabinet.

The gas deal was among the chief sources of popular rage against the ousted regime of President Hosni Mubarak and one of Mr. Mubarak´s most unpopular foreign policy positions.

Since Mr. Mubarak was ousted amid massive street protests last February, militants have bombed the pipeline that delivers natural gas from Egypt to Israel and Jordan at least 13 times, effectively cutting off supply at normal levels ever since. Gas deliveries dried up for a total of 225 days in 2011 and 66 days during the first three months of 2012, according to Ampal´s website. Gas has not flowed to Israel from Egypt since an explosion on March 5. The cutoff in gas supply has caused a surge in fuel costs at Israel´s electric utility, prompting rates to surge 33%.

EMG began international arbitration proceedings against EGAS in October 2011 to potentially demand billions of dollars in remuneration for the lost gas.

Mr. Mubarak now faces criminal charges for his role in the deal, which is popularly believed to sell off Egyptian natural resources to the despised Israeli government at below-market rates.

Hussein Salem, a co-owner of EGAS and close confidant of Mr. Mubarak, was arrested last June in Spain where he faces a possible extradition to Egypt and prosecution for his role in the gas deal.

Israeli officials have long maintained that the contract´s terms are fair. But many Egyptians believe that the Mr. Salem benefited hugely from his middle-man role.

EMG has not made its prices public, but some analysts and industry experts suggest it could be about $2 to $3 per British thermal unit. Egypt´s government sells natural gas to Egyptian companies for about $4 per btu.

"The big saying here in Egypt is that we are subsidizing the Israeli people while we are not subsidizing the Egyptians," said Tamer Abu Bakr, the chairman of Genco Group, an Egyptian natural gas distribution company.

Successive petrol and natural gas shortages throughout the past four months have sharpened anxiety about the gas deal. Anti-Israel rhetoric from presidential candidates vying in Egypt´s May elections has also raised public anger over the gas exports.

The 2005 gas deal was a 20-year supply agreement that yielded about $300 million for Egypt in 2010 and reduced Israel´s energy costs. The supply agreement was included as an annex to the 1979 peace agreement, highlighting its legal and symbolic significance to bilateral ties.

But the arrangement has become a source of frustration and political anger for both sides.

The contract calls for EMG to deliver 7 billion cubic meters, or BCM, of Egyptian natural gas to Egypt every year, which would offer Egyptian state-owned gas firms over $1 billion each year, according to Ampal´s website.

By the end of 2010, EMG had only provided 2.5 BCM to Israeli utilities company each year since the gas started flowing in June 2008.

A spokesman for Israel´s Infrastructure Ministry said the government had not yet gotten an official announcement. A spokesman for the prime minister´s office was also unaware of the development.

Despite government statements that Israel has prepared for the cutoff of gas from Egypt, the loss of gas flow has been felt because it accounted for 16% of the country´s power generating capacity.

Already in 2011, the supply cut from Egypt contributed to a rise in electricity rates for Israeli consumers. Israel Electric Co., the state-owned utility, is preparing for rolling black outs in the summer, in part due to the shortfall of gas suppy from Egypt. (Copyright © Dow Jones & Company, Inc.) 04/23/12)