After repeated protests to China about its exploration in nearby waters, Japan's Trade Ministry said on Wednesday it would allow gas drilling in waters within its western sea border - a line that China disputes.
Approval for drilling is expected within two to three months, a Japanese Foreign Ministry official said.
Tokyo also said the gas fields where China is test-drilling may extend into Tokyo's waters, but Beijing says its surveys are within its exclusive economic zone.
Chinese Foreign Minister Qin Gang immediately labelled Tokyo's decision a "provocation" on Wednesday and said Beijing retained "the right to take further action".
The latest row follows a weekend of anti-Japanese protests in Beijing and two other Chinese cities, following Japan's approval of a history textbook that critics say plays down Japanese wartime atrocities such as the forced prostitution of thousands of Asian women.
In Beijing, protesters pelted the Japanese Embassy with rocks and bottles, vandalised Japanese businesses and attacked two Japanese nationals.
Japan has demanded compensation and an official apology.
Anti-Japanese sentiments have
surged in China in recent weeks
Beijing has refused to tender any. Analysts said the two nations' relations were at their lowest in decades.
History professor and expert on Sino-Japanese relations Tokuji Kasahara said that ties "haven't had a falling out like this since establishing diplomatic ties in 1972".
But China, South Korea and other nations in the region have long accused Japan of failing to show its contrition for brutal regional conquests in the early 20th century.
Many Asian nations also protest Koizumi's annual visits to a Tokyo shrine honouring Japan's war dead - including convicted wartime criminals - and his attempts to broaden the military's role in global peacekeeping operations such as Iraq.
North Korea, an ally of China, and South Korean legislators also weighed in on Wednesday. "This betrays philistinism peculiar to Japan, a vulgar and shameless political dwarf," a Foreign Ministry spokesman said in a statement carried by the North's official news agency, KCNA.
Visiting South Korean legislators told Japanese Foreign Minister Nobutaka Machimura on Wednesday that Tokyo should "correct its attitude" and stop defending its wartime past.
"Japan has reflected deeply on its past"
Japan's Chief Cabinet Secretary
However, Japan's Chief Cabinet Secretary Hiroyuki Hosoda insisted that "Japan has reflected deeply on its past".
The stakes are high for both China and Japan, as they compete for regional dominance and potentially rich energy sources needed to power their massive - and increasingly integrated - economies.
Over to UN
China is Japan's second-biggest trading partner, behind the US, with two-way shipments totaling $170 billion in 2004.
Political discord could disrupt shipments from Japanese companies' China-based plants and spark boycotts of Japanese goods by Chinese consumers, while prompting Japanese executives to curtail investments in China.
Tokyo says China is test-drilling
in Japanese territorial waters
On Tuesday, Chinese Prime Minister Wen Jiabao indicated that Beijing might oppose a bigger role for Japan at the UN.
Under sweeping reforms UN Secretary-General Kofi Annan has said he wants approved this year, Japan could gain a permanent seat on the council - alongside the US, Britain, Russia, France and China.
The move would come in recognition for Japan's status as the world's second-biggest economy and second-largest financial contributor to the UN after the US.
But to do so, the UN charter would have to be amended by the Security Council, and China could use its veto to block any change.
"Only a country that respects history, takes responsibility for history and wins over the trust of peoples in Asia and the world at large can take greater responsibilities in the international community," Wen said during an official visit to India.