China set up an office of commercial development in Panama in 1996.
Panama's decision leaves Taiwan with only 20 diplomatic allies in the world, 11 of them being in Latin America and the Caribbean.
REUTERS Greg Baker PoolChina Panama Officially Establish Diplomatic Ties
The two governments agree to develop friendly relations between the two countries on the basis of the principles of mutual respect for sovereignty and territorial integrity, mutual non-aggression, non-interference in each other's internal affairs, equality, mutual benefit and peaceful coexistence, the communique said.
"The Government of the Republic of Panama recognizes that only one China exists in the world, the Government of the People's Republic of China is the only legitimate Government that represents all China and Taiwan forms an inalienable part of Chinese territory", the statement read.
As recently as December, Panama's deputy foreign minister had said he did not expect any change in Panama's relations with Taiwan or China.
Monday's diplomatic move could also raise questions about the future of a Chinese-backed project to build another Central American waterway to rival the Panama Canal in Nicaragua.
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