The decision was taken at a second session of National Security Committee (NSC) within a week presided over by Prime Minister Imran Khan to review the situation following the Indian government's move on Kashmir.
"Our ambassadors will no longer be in New Delhi and their counterparts here will also be sent back," Foreign Minister Shah Mahmood Qureshi told ARY News.
According to a statement issued after the meeting, the NSC decided to downgrade diplomatic relations, suspend bilateral trade with India, review of bilateral arrangements, take the matter to the UN and observe Pakistan's Independence Day on 14 August in solidarity with Kashmiris.
"The Prime Minister directed that all diplomatic channels be activated to expose brutal Indian racist regime, design and human rights violations," said the statement issued after the meeting.
The meeting was attended by Defence Minister Pervez Khattak, Foreign Minister Shah Mehmood Qureshi, Chairman Joint Chiefs of Staff Committee General Zubair Hayat, Army Chief General Qamar Bajwa, Naval Chief Admiral Zafar Mehmood Abbasi, Chief of Air Staff Air Chief Marshal Mujahid Anwar Khan, ISI Director-General Lt Gen Faiz Hameed and other officials.
"Independence Day this August 14 to be observed in solidarity with brave Kashmiris and their just struggle for their right of self-determination," the statement read. "August 15 will be observed as Black Day," it added.
On Tuesday, Imran Khan, addressing a joint session of the National Assembly, had said that Pulwama-like attacks can follow the revocation of the special status for Jammu and Kashmir, which can lead to a war between India and Pakistan.
"I can already predict this will happen. They will attempt to place the blame on us again. They may strike us again, and we will strike back," the cricketer-turned-politician told his country's Parliament.
Slamming the repeal of special status to Jammu and Kashmir, Khan had called on the world to raise its voice "for the people of Indian-Administered Kashmir".
The last NSC meeting was held on 4 August to discuss India's "use of cluster ammunition to target the civilian population on the Pakistani side of Kashmir".