Armenia said it was suspending diplomatic relations with Hungary on Friday because it had allowed an Azeri soldier who killed an Armenian officer in 2004 to return home, where he was immediately pardoned and freed.
"Hungarian authorities should understand that they have made a grave mistake," President Serzh Sarksyan told his Security Council in a statement posted on his website.
"They de-facto made a deal with the Azeri authorities."
The row erupted after Azerbaijan President Ilham Aliyev pardoned Ramil Safarov, who had been sentenced to life in prison for the 2004 killing of Armenian officer Gurgen Markaryan during NATO training in Hungary.
Hungary agreed to return Safarov to Azerbaijan, where he arrived on Friday, after it had received assurances he would serve out his sentence.
Within hours of the announcement of Safarov's release, Sarksyan called an emergency meeting of his Security Council.
"I officially announce that as of today we cease all diplomatic relations and all ties with Hungary," Sarksyan said in a press release distributed by his administration.
Armenia and Azerbaijan have been at odds since the war between ethnic Azeris and Armenians which erupted in 1991 over the mainly Armenian Nagorno-Karabakh enclave. A ceasefire was signed in 1994 but relations remain tense.
Cross-border clashes this year have prompted worries of a resumption of fighting in a region crisscrossed by energy pipelines to Europe.
Nagorno-Karabakh has run its own affairs with the heavy military and financial backing of Armenia since the war, when Armenian-backed forces seized control of the enclave and seven surrounding Azeri districts.
Russia, France and the United States have led years of mediation efforts under the auspices of the OSCE. Baku and Yerevan failed to agree at talks in June last year and the angry rhetoric between them has worsened since then.
Hungary has been developing economic ties with energy-rich Azerbaijan and gave backing to the Nabucco pipeline project seen as the main route for Azeri gas exports to Europe. Hungarian media reported that Azerbaijan could lend Hungary 2-to-3 billion euros ($2.5-3.8 billion).
Oil-producing Azerbaijan, which is host to oil majors including BP, Chevron and ExxonMobil, frequently threatens to take the mountain enclave back by force, and is spending heavily on its armed forces.
