“This will likely make the North Koreans feel less secure in operating in countries that have closer ties to the U.S. than them,” said Go Myong-hyun, a research fellow at the Asan Policy Institute in Seoul. “Because now they know they can be sent to the U.S.”

The accused North Korean, Mun Chol Myong, is wanted by U.S. authorities on suspicions of money laundering and violating U.N. sanctions, according to Malaysia’s foreign ministry.

North Korea denied the accusations against Mr. Mun, saying he was engaged in legal business activities. “It is absurd fabrication and sheer plot to argue that he was involved in ‘illegal money laundering,’ ” Pyongyang’s foreign ministry said Friday.

Accusing Malaysia of a hostile act, Pyongyang said it would immediately sever diplomatic ties with the Southeast Asian country. North Korea also said the U.S. would pay a price.

An attorney for Mr. Mun in Malaysia declined to comment.

The U.S. Department of Justice declined to comment. The Treasury Department didn’t immediately respond to a request for comment.

Washington asked Kuala Lumpur for his extradition in May 2019, according to Malaysia’s foreign ministry.

The U.S. has sought to cut off North Korea from the global financial system through sanctions to prevent it from furthering its nuclear weapons program. Sanctions enforcement, though, has been imperfect. North Korea conducts much of its illicit money-earning schemes, such as cyberhacking or exporting sanctions-banned goods, in countries where the U.S. has no jurisdiction or in those that are considered adversaries of Washington such as China or Russia.

Sanctions monitors have long suspected North Korea of using Malaysia as a hub for illicit money-earning schemes. In multiple reports, a U.N.-appointed panel of experts have mentioned Malaysia Korea Partners, a company based in Malaysia that earned cash for North Korea.

The company created a global network that undertook projects in Africa, Hong Kong, and the Middle East, allegedly in an effort to evade sanctions. It has carried out services in information technology, construction, mining, coal trading, security and transportation, the U.N. has said.

Relations between Malaysia and North Korea have been deteriorating since Kim Jong Nam, the elder half-brother of North Korean leader Kim Jong Un, was killed there in 2017 with an internationally-banned nerve agent. The U.S. and South Korea have accused Pyongyang of being behind the killing, which it has denied.

North Korea’s decision to cut diplomatic ties with Malaysia may in part be an indication that Pyongyang is no longer able to effectively use the country to evade sanctions, said Woo Jung-yeop, a research fellow at the Sejong Institute, a think tank near Seoul. “If they still felt they could earn meaningful money there, they’d likely wanted to have kept their embassy,” he said.

The U.N. has said North Korean diplomats based in foreign countries, including Malaysia, have participated in sanctions evasion work for the cash-strapped Kim regime. Malaysia and North Korea have had diplomatic relations since 1973.

Friday’s statement also comes as relations between the Biden administration and North Korea have had a rocky start.

North Korea has rebuffed U.S. outreach for talks over the phone and email since mid-February, American officials have said. Instead, top Pyongyang officials lashed out at the U.S. in public statements this week as President Biden’s secretaries of state and defense were visiting Japan and South Korea.

On Tuesday, Kim Yo Jong, the sister of North Korea’s leader, warned the Biden administration against “causing a stink.” On Thursday, Choe Son Hui, a senior Pyongyang diplomat, said North Korea wasn’t interested in returning to long-stalled nuclear negotiations with Washington. The Biden administration, meanwhile, is nearing completion of a policy review on North Korea.

Write to Andrew Jeong at andrew.jeong@wsj.com