China, the world's second-largest consumer of oil, is to raise the price of petrol and diesel by 18%.
The move, which could depress demand for oil from the fast-growing economy, caused the price of crude to fall $4.
US light, sweet crude fell to $132 on the news, along with confirmation from Saudi Arabia that it will boost the level of its oil production.
China's fuel subsidies have helped support the country's growing demand for the commodity.
Retail fuel prices will increase by 1,000 yuan ($145.40; £73.80) a tonne from Friday, while aviation fuel will rise by 1,500 yuan a tonne.
"Global crude prices have been rising sharply and Chinese domestic fuel prices have lagged behind. The price difference has highlighted the contradiction between demand and supply," said Chinese state television, quoting the country's National Development and Reform Commission.
The move came as a surprise, as China had ruled out any cuts in subsidies ahead of this summer's Beijing Olympics.
It is the first cut in subsidies for eight months and there are fears it will stoke inflation in China.
Electricity tariffs will also go up, although some residents and some parts of agricultrural production will be exempt from the price rise.
Oil price falls
The prospect of lower demand from China and increased supply from Saudi Arabia caused US light, sweet crude to fall $4.02 to $132.66 in New York.
"This could change the psychology of the market completely," said James Cordier from Liberty Trading Group, referring to the anticipated fall in demand from China.
Analyst Eric Wittenauer from Wachovia Securities agreed. "As the developing countries of the world are underpinning the demand side of this market, this could prove bearish for commodities," he said.
Saudi Arabia has confirmed that it will boost production of oil by 200,000 barrels a day in July.
This will take its production up to 9.65 million barrels a day.
The Saudi statement came ahead of a summit in Jeddah on Sunday, where major oil producers and senior politicians, including British Prime Minister Gordon Brown, will discuss record oil prices.
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