Taiwan expressed "anger and regret", and accused Panama of "bullying".
China regards Taiwan as a breakaway province. A few countries maintain ties with Taipei instead of Beijing, and Panama is the latest to switch sides.
In December last year, the African island nation of Sao Tome and Principe made a similar move. Now only 20 countries have diplomatic relations with Taiwan.
In recent years China has intensified its economic investment into the Central American country - home of the economically vital Panama Canal.
Taiwan's foreign ministry said in a statement that it expressed "anger and regret" over what it called a "very unfriendly" diplomatic turn by Panama that "yielded to economic interests by the Beijing authorities".
It accused Panama of "bullying" Taiwan while "ignoring the many years of friendship" between the two countries, and added it would "not compete with the Beijing authorities for money diplomacy".
Following Panama's announcement, China's state media published photos of the two countries' foreign ministers in Beijing signing a document establishing diplomatic relations and toasting with champagne.
Panamanian President Juan Carlos Varela said in a televised address that he was "convinced that this is the correct path for our country".
China's foreign ministry also released a statement (in Chinese) saying that "the Chinese government and its people highly appreciate and warmly welcome" the move by Panama.
The United Nations in 1971 switched diplomatic recognition to Beijing's People's Republic of China (PRC) and most countries have since followed that lead in order not to antagonise the resurging economic giant.
Many of Taipei's remaining backers are small island states or in Central and South America - regions that in the past had limited economic ties with China.
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