The US president announced yesterday that joint military exercises next month were cancelled and that normal cooperation between the countries could not continue while civilians were being killed.
Egyptian security forces said they will use live ammunition to counter any attacks against themselves or public buildings, state television announced.
Protesters torched a government building in a Cairo suburb after hundreds of Egyptians died following a fierce security crackdown on the Muslim Brotherhood, supporters of President Mursi, on Wednesday.
At least 525 people have been killed - including British Sky News cameraman Mick Deane, who was shot - and thousands wounded.
Seven Egyptian soldiers were also shot dead by unknown gunmen near the city of El-Arish, a lawless area.
Speaking while on holiday at Martha's Vineyard, President Obama said: "The United States strongly condemns the steps that have been taken by Egypt's interim government and security forces.
"We deplore violence against civilians. We support universal rights essential to human dignity, including the right to peaceful protest."
The joint military drill, Bright Star, scheduled for next month has been scrapped for the first time since 1981.
It is a cornerstone of US- Egyptian military relations and began after the Camp David Peace Accords between Egypt and Israel.
President Obama added: "While we want to sustain our relation-ship with Egypt, our traditional co-operation cannot continue as usual when civilians are being killed in the streets and rights are being rolled back.
"The Egyptian people deserve better than what we have seen over the last several days. And to the Egyptian people, let me say: the cycle of violence and escalation needs to stop."
In Cairo, chaos reigned a day after security forces carried out Wednesday's killings, filling the morgue and the street outside.
Dozens of bodies in blankets, white sheets and newspapers formed a queue of death stretching hundreds of metres down the derelict cul-de-sac in front of Zeinhom morgue.
President Obama said the state of emergency should be lifted and a process of national reconciliation started.
The Egyptian soldiers died near El-Arish in the lawless North Sinai region and five soldiers were injured when gunmen opened fire on an army tent in a separate incident.
Egypt said yesterday it would shorten the hours of a curfew imposed on Cairo and 13 other cities following the political violence.
The curfew will now start at 9pm instead of 7pm, and it will last until 6am.
Having failed to dissuade Egypt's military-dominated rulers from launching a bloody crackdown on supporters of an ousted Islamist president, Western governments are venting condemnation and groping for ways to influence the outcome.
The US and the European Union tried jointly to facilitate a peaceful, political solution to the stand-off between the army and the Muslim Brotherhood, appealing right to the end to avoid violence.
Meanwhile, Egypt's ambassador to the UK has insisted that the crackdown ordered by authorities was a proportionate response.
Ashraf El-Kholy said the large death toll was partly due to protesters killing each other due to their own recklessness.
He said the police and army "did nothing but return fire", adding: "If you have somebody firing at you then you have to respond."
The UK Government has "condemned the use of force" to clear two protest camps, and Mr El-Kholy was yesterday warned of the UK's "deep concern" at events when he was summoned to the Foreign Office for a meeting.