But Ram Baran Yadav, the president and a member of the main opposition
party, told the head of the army to remain in his position.
"The move by the president is an attack on this infant democracy and the peace process," Dahal said, accusing the president of having taken an "unconstitutional and undemocratic decision".
"The interim constitution does not give any right to the president to act as a parallel power," he said.
The Maoists have vowed to launch demonstrations and shut down the government in protest at the president's action.
"We have decided to begin mass protests ... and stall parliament until the president takes back his decision," Nath Sharma, the Maoists' party spokesman, said.
Nepal's Communist party (UML), a crucial Maoist ally, on Sunday quit the government, angered at the Maoists' attempt to sack Katawal.
After the resignation of Prachanda, who has been prime minister for just eight months, the government has effectively collapsed.
"A coalition is trying to be cobbled together tomorrow [Tuesday], when 24 parties out of the 25 in the constituent assembly meet to hammer out who the next leader will be," Joydeep Sengupta, a journalist with the Himalayan Times newspaper in Kathmandu, told Al Jazeera.
"As of now, the president has accepted the resignation of the prime minister, and has asked him to continue with his duties until the next council of ministers' [meeting].
"The Maoists don't have the numbers in the legislative parliament; they have only 238 MPs in the 601-member house."
Concerns have grown over what the dispute will mean for the peace deal, which brought the Maoists into the political mainstream and ended their "people's war".
The Maoists won landmark elections last year and forced the abdication of the king.
|The army views the former Maoist fighters as politically indoctrinated [GALLO/GETTY]
Since then they have been pushing to finalise the peace process by having their former fighters incorporated into the military.
But the army views the former Maoist fighters as politically indoctrinated and has refused to absorb them.
Subina Shrestha, Al Jazeera's Nepal correspondent, said: "The has been a row going on between the government and the army for a while.
"One of the main points of the peace agreement was that the 19,000 members of the PLA - the People's Liberation Army - were supposed to be incorporated into the national army, but that has not happened.
"The army has been against it and it has been resisting for a long time," she said.
The army also accuses the Maoists of not fulfilling their commitments to return property grabbed during the civil war and disband its youth wing, the Young Communist League.