Mr Netanyahu’s shock announcement comes amid intensifying security concerns, 10 days before the pull-out is due to begin on August 17.
“The moment of truth has come. I cannot sanction a decision which threatens state security,” Mr Netanyahu said in his resignation letter.
Mr Netanyahu, Prime Minister Ariel Sharon’s main rival for the leadership of their right-wing Likud party, has made no secret of his opposition to the pull-out, Israel’s first ever withdrawal from occupied Palestinian land.
“I acted according to my conscience, but I don’t expect to stop the disengagement plan because it has an automatic majority in the government,” he told a news conference.
Mr Netanyahu, a hardliner and former prime minister, stressed he was opposed to disengagement as a unilateral gesture which gives Israel nothing in return.
He says a withdrawal from the Gaza Strip would allow militancy to fester unchecked and would put Israel’s security at risk.
The resignation of Mr Netanyahu sent local financial markets reeling and showed the depth of division in the cabinet over the plan for “disengagement” from conflict with the Palestinians.
Mr Sharon swiftly named his closest cabinet ally, Deputy Prime Minister Ehud Olmert, to take over the finance portfolio on a caretaker basis.
Palestinian chief negotiator Saeb Erakat said he hoped Mr Netanyahu’s resignation would not affect the Gaza pullout.
The evacuations of the three most isolated settlements in Gaza
– Netzarim, Kfar Darom and Morag -easily won cabinet approval by 17 votes to five.
Meanwhile police announced that the first three administrative detention orders, normally used against Palestinians, had been imposed on Jewish hardliners.
All three, including one US national, are considered close to the outlawed anti-Arab group Kach.
Administrative detention orders allow individuals to be held without trial for renewable periods of three to six months on the decision of an Israeli military commander.
Detainees can appeal to a military commission or to the Israeli Supreme Court.
Some 700 Palestinians are currently subject to administrative detention.