Israeli army radio said on Wednesday Yaalon will retire after completing his three-year term in July, just before Israel is to begin its pullout from the Gaza Strip.
The radio quoted Defence Minister Shaul Mofaz as saying that Lieutenant-General Yaalon would not be given the customary fourth year extension as army chief.
Walid al-Umari, director of Aljazeera's Palestine office said Israeli army officers were shocked with the decision because according to them, Yaalon had led the war against the Palestinian intifada to a strategic turning point.
Al-Umari said the decision was related to disagreements between the army and political leadership over the withdrawal from Gaza and the handover of authority to the Palestinians.
Israeli newspaper Haaretz said Yaalon had been offered a six-month extension but demanded a year's extension or not at all.
A statement issued by the defence minister's office said it was a decision in principle, and Yaalon's successor, who has not yet been picked, would also serve only three years.
Haaretz reported that deputy chief of staff Dan Halutz and his predecessor Gabi Ashkenazi have been tipped as candidates to succeed Yaalon.
The pullout from Gaza and part of the West Bank is seen as an especially sensitive issue for the army.
Violence in the West Bank may
halt further peace initiatives
Hardline Israeli settlers are mounting a campaign to sign up soldiers on a petition to disobey orders to take part in the evacuation of the 21 Gaza and four West Bank settlements.
Several groups of soldiers and officers have sent letters to Mofaz saying they would refuse to take part in the operation.
Israel is coordinating its pullout from Gaza with Palestinian officials, Sharon said, as his parliament was to give final approval to the withdrawal on Wednesday.
However, violent incidents in the West Bank on Tuesday threatened to upset
the positive atmosphere of a truce declared last week.
Sharon originally envisioned the Gaza pullout as a unilateral move, but said at a press conference on Tuesday he was ready to work with the new Palestinian leadership of Mahmud Abbas.
"We already started to coordinate," he said. "I instructed to start coordination of our withdrawal ... from Gaza."
The prime minister said he hoped coordination with Abbas would prevent fighters from taking over once Israel left Gaza.
"Israel must choose between settlements or peace. It cannot have both"
Saib Uraiqat, Palestinian negotiations minister
Palestinian legislative elections are set for July, coinciding with the start of the pullout. Resistance group Hamas is seen as a strong challenger to Abbas' Fatah party.
Sharon said his plan would solidify Israel's grip on main settlement blocs in the West Bank, which "will be part of the Jewish state in the future".
Reacting, Palestinian Negotiations Minister Saib Uraiqat said: "Israel must choose between settlements or peace. It cannot have both."
He said no peace plan could be imposed on Israel, insisting on sticking with the internationally backed road map plan.
However, he said, negotiations had not resumed on the plan. He hoped the two sides were on the way to talking about the road map, which leads, through stages, to a Palestinian state.
Israeli and Palestinian negotiators, meanwhile, were deadlocked over the terms of an Israeli withdrawal from the West Bank town of Jericho.
Sharon said West Bank blocs will
become part of the Jewish state
The Palestinians want Israel to hand over adjacent territory as well, including the village of al-Awja, and dismantle checkpoints in the area.
But Israel wants to keep the main checkpoint at Jericho's entrance in place, and balks at giving up control over al-Awja because a highway used by Israelis runs through it.
Jericho is the first of five towns to be handed back to Palestinian control according to agreements at the Sharm al-Shaikh summit last week. The transfer was originally set for Tuesday.
Israeli troops killed two armed Palestinians on Tuesday night, whom the army said approached a West Bank settlement.
The two were members of al-Aqsa Martyrs Brigades, a group with ties to the Fatah movement
Al-Aqsa members said the two armed men were guarding an abandoned Palestinian house near the settlement and were killed by Israeli troops without provocation.
Al-Aqsa members indicated they would retaliate.
Palestinians also said Israelis shot and killed a 14-year-old who was throwing rocks at soldiers. The Israeli military denied soldiers opened fire.
Early on Wednesday, Palestinian fighters in Gaza fired a mortar round at a Jewish settlement in the coastal area. No injuries or damage were reported.
Incidents like these have triggered the retaliation and counter strikes that buried earlier truces during more than four years of violence.