Tens of thousands of military and civilian posts will be lost, elderly warships and fighter jets will be phased out, while light, mobile artillery regiments will replace heavy tank units, Defence Secretary Geoff Hoon said.
The cuts, slammed by the opposition as "foolhardy", were needed because the country faced very specific military needs in the post-Cold War era, Hoon told parliament.
"The threats to Britain's interests in the 21st Century are far more complex than was foreseen following the disintegration of the Soviet Empire," he said.
Britain needed to "modernise the structure of our armed forces, to embrace new technology, and to focus on the means by which our armed forces can work together with other government agencies to meet the threat of international terrorism and the forces of instability in the modern world", he said.
The changes will see the Royal Air Force (RAF) shed about 7500 posts and the Royal Navy 1500 by 2008, while the army will be slimmed down to 102,000.
While the army currently numbers just over 112,000, a ministry of defence spokesman said the reduced figure was intended to refer to full-time trained strength, which stands just below 104,000 at the moment.
A further 10,000 jobs would also go among civilian personnel attached to the armed forces, Hoon said.
In the navy 12 vessels will be pensioned off, including three Type 42 destroyers, a model dating back originally to the late 1960s.
The RAF will lose four squadrons of Tornado and Jaguar jets, while the axe will fall entirely on RAF Coltishall, an air base in eastern England which played a prominent role in the Battle of Britain of 1941.
"Iraq has shown that winning the peace needs more troops on the ground than winning the war"
Liberal Democrat defence spokesman
The army will meanwhile see four infantry battalions disappear, along with a series of squadrons using Challenger 2 tanks and heavy artillery batteries, although the latter will be balanced by new light armoured outfits.
Nicholas Soames, defence spokesman for the main opposition Conservative Party, said that while reorganisation was needed, the public would find it "extraordinary" that overall numbers were being cut when the military was so stretched in Iraq.
Service personnel would feel "betrayed politically and morally", he said.
Liberal Democrat defence spokesman Paul Keetch slammed the moves as "foolhardy".
"Iraq has shown that winning the peace needs more troops on the ground than winning the war," he said.
"These changes assume no new commitments. A bit of spare capacity would have been a good insurance policy."