Arla UK said it would slash 0.66 pence per litre (ppl) off the price it paid most of its supplier farmers for their milk.
The firm added it would fine producers an extra 0.45ppl, from July to the end of September, if they strayed more than 10 per cent below or above average milk production.
The moves are the latest of several price cuts by processors this year and have increased concerns about the viability of the UK dairy sector going forward, amid a serious earnings problem throughout the supply chain.
Producer groups criticised Arla for further suppressing earnings in the sector.
The National Farmers' Union (NFU) said it was holding urgent talks with dairy industry officials on the issue. "There is no future for a dairy industry which continues to squeeze producers. Dairy farmers will vote with their feet and milk production will drop leading to inefficient processing plants and job losses," said Gwyn Jones, head of the NFU's Dairy Board.
Even the Milk Development Council (MDC), a levy-funded body and normally neutral, said that Arla appeared to be favouring penalties for farmers instead of incentives.
The average farmgate milk price in the UK is around 18ppl, below the cost of production for many producers and unsustainable in the long-term, according to producer groups.
A recent MDC survey of 682 milk producers found that more than one in ten (14 per cent) planned to leave the sector within the next two years.
The storm that Arla has cooked up, however, is also another example of the intense cost pressures faced by Britain's dairy processors themselves. The firm reported a loss of £0.9m in its recent first half results, after profits of £25m for the same period the year before.
Supermarkets have, almost inevitably, become a target.
Both Arla and rival processor Dairy Crest lambasted supermarkets last month for cutting retail milk prices by around 14 per cent in March, eroding gains made through price rises in January.
Arla said the move raised "concerns over the future attitude of supermarkets to the sector".
Several reports by both industry bodies and the government have called for a more united industry approach to raise dairy sector earnings.
Gwyn Jones, a strong supporter of this approach, repeated the call following Arla's announcement. "The whole sector needs to stand together to resist retail pressure," he said.
There have also been calls for greater sector co-operation to develop more added value dairy products.
The UK's continuing over-reliance on commodity dairy ingredients is a problem, at a time when the European Commission is to wean member states off them via price cuts in its Common Agricultural Policy reform.
The UK trade deficit for dairy products rose by 20 per cent in 2005 to £893m, after jumping £300m in the five years before that, according to the MDC. It said this was because the UK continued to import large amounts of added value dairy, while exporting lower value commodities, like milk powders and bulk cream.
Faced with these challenges, most see more consolidation on Britain's dairy industry as inevitable over the next few years.
There are those who question whether a drop in milk production would be such a bad thing. Tim Smith, Arla UK's chief executive, said recently that cutting one billion litres out of Britain's milk production may help those remaining in the sector work more profitably.