Angry protesters gathered outside Israel's embassy in Cairo Israel has promised to investigate the deaths, amid claims that Israeli forces killed the officers while chasing suspected Palestinian militants.
It is the first time in a decade that Egypt has withdrawn its ambassador.
The BBC's Yolande Knell in Jerusalem says it marks a sharp escalation in tensions between Israel and Egypt.
The 30-year-old peace treaty was already being tested after the long-time Egyptian leader Hosni Mubarak was forced from office earlier this year, our correspondent says.
'Erosion of order' The latest violence began on Thursday when gunmen attacked buses near the Israeli Red Sea resort of Eilat, killing eight people.
Egyptian officials say Israeli forces chased the suspected militants across the border, and a number of people were killed - including the policemen.
Hundreds of Egyptians protested outside the Israeli embassy in Cairo overnight, burning the Israeli flag and demanding that the Israeli ambassador be expelled from the country. Protests were reportedly continuing on Saturday morning.
Protesters called for the embassy to be closed and the ambassador expelled. They burned the Israeli flag and tore down the metal barriers at the entrance of the embassy. Some protesters carried pictures of the late Egyptian President Gamal Abdel Nasser, known for his open anti-Israeli stance.
Such scenes were unheard of during the Mubarak era.
Security is tight around the embassy, two military vehicles could be seen in front of the building, and armoured emergency vehicles were also at the scene.
Such scenes were unheard of during the Mubarak era.
Security is tight around the embassy, two military vehicles could be seen in front of the building, and armoured emergency vehicles were also at the scene.
"We don't want any ties with Israel," one protester Ahmed Aggoura told the BBC.
"Israel is only interested in a subservient Egypt not a free Egypt. By protesting outside the embassy we're sending them a clear message. This is not Mubarak's Egypt any more. If you kill our soldiers, there will be consequences." On Friday, in Egypt's second city, Alexandria, a protester managed to take down the Israeli flag from the consulate there and replaced it with Egyptian and Palestinian flags.
After the initial Eilat attack, Israel had expressed concern about security in the Sinai Peninsula and said Palestinian attackers had reached Eilat after entering Egypt from Gaza and travelling through the Sinai desert.
But the Egyptian cabinet issued a statement on Saturday denying it had lost control of the Sinai and demanding an apology from the Israeli leadership over "the sad and hasty remarks about Egypt".
"The Egyptian ambassador to Israel will be withdrawn until we are notified about the results of an investigation by the Israeli authorities," said the statement.
Cairo said it regarded the attack as a breach of the 1979 peace treaty between the two nations, and blamed Israel for lax border controls.
Under Mr Mubarak ties between the two nations had been stable after a history of conflict.
But Mr Mubarak's ousting in a popular uprising has sparked fears among Israeli officials that a less amenable government could take charge in Cairo.
And correspondents say the Sinai desert region of Egypt has become increasingly lawless since Mr Mubarak was ousted, with a rise in al-Qaeda-inspired militant activity.
Speaking to the BBC's Today programme on Friday, Israeli government spokesman Mark Regev warned there had been an "erosion of law and order in some parts of Sinai in the last few weeks".
But he added: "Israel and Egypt have a common interest in the border remaining quiet and not allowing extremist elements to establish a platform in Sinai.
"I understand that the Egyptians have no interest whatsoever in once again extremist elements escalating violence along the border."
Since Thursday's attacks, Israeli aircraft have repeatedly attacked targets in the Gaza Strip, while Palestinian militants have fired more than 20 rockets into Israel.
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