The AU's Peace and Security "council decided to suspend the participation of Egypt in AU activities until the restitution of constitutional order", said an official statement.
The pan-African bloc met on Friday at AU headquarters in the Ethiopian capital to discuss the political crisis in Egypt, following Morsi's removal by the army on Wednesday.
"The council reiterates the AU's condemnation and rejection of any illegal seizure of power," the statement added.
"The overthrow of the democratically elected president does not conform to the relevant provisions of Egypt's constitution, and therefore falls under the definition of an unconstitutional change of government."
Ahead of the meeting, AU commission chief Nkosazana Dlamini-Zuma stressed its "principled position" on such changes of government.
However, Mohamed Edrees, Egyptian ambassador to the AU, said ahead of the decision that "the voice and the call of tens of millions of Egyptians must be heard, understood and respected".
Speaking Friday before the suspension, Edress said that Egypt wanted to maintain its role in the AU and "continue to take part in this family".
"The military role is to support the people, their role is not to instigate a coup," Edress added.
"Since the start of the Arab spring, it posed a challenge to the instrument of the African Union. The AU, at that time, the council decided that what happened in Egypt was a popular revolution and it dealt with it accordingly."
The bloc has previously suspended members which broke its rule of unconstitutional changes of government, most recently in March when it suspended the Central African Republic after rebels seized power.
Madagascar and Guinea-Bissau are also suspended.
Muslim Brotherhood holds protests
Thousands of supporters of Egypt's Muslim Brotherhood on Friday protested in Cairo ahead of a wave of mass rallies called to reject the military's ouster of Islamist president Mohamed Morsi.
"May God bring Morsi back to power," and "May God end the rift between us and the army," the imam leading the prayer told worshippers at the Rabaa al-Adawiya mosque.
Ahead of the rallies, around a dozen low-flying military jets screeched across Cairo, a day after they staged a parade leaving a trail of smoke in the shape of a heart in the sky.
The call for "peaceful protests" across Egypt came from the Brotherhood's recently formed National Alliance to Support Legitimacy, which it said were against "the military coup" and in support of Morsi.
The deposed leader, who has not been seen since Wednesday, had issued a defiant call for supporters to protect his elected "legitimacy", in a recorded speech hours after he was toppled.
With thousands of Morsi supporters camped outside the Rabaa al-Adawiya mosque encircled by military vehicles, the call for demonstrations raised fears of fresh violence after days of bloodshed.
The military said it supported the right to peaceful protest, but warned against violence and acts of civil disobedience such as blocking roads.
Human Rights Watch called for "prompt, impartial investigations to determine who was responsible for killings" since late June.
"The available information indicates that both supporters and opponents of Morsi — and possibly security forces as well — were responsible for needless loss of life," said HRW's Joe Stork.
In the Sinai, Islamist militants killed a soldier early Friday, as gunmen ambushed army and police positions with machineguns and rockets.
State news agency MENA said military Apache helicopters struck a militant's vehicle in pursuit of gunmen who attacked an airport in the north of the restive peninsula.
The army boosted security in the peninsula in response, officials said.
Some militants in the Sinai had threatened a violent response after Morsi's ouster on Wednesday.
Clashes also broke out in the Nile Delta province of Sharqiya, hours after chief justice Adly Mansour, 67, was sworn in on Thursday as interim president until new elections.
The army warned Egyptians against resorting to "exceptional and autocratic measures against any political group".
"The armed forces believe that the forgiving nature and manners of the Egyptian people, and the eternal values of Islam, do not allow us to turn to revenge and gloating," added the army, even as security forces rounded up top Muslim Brotherhood officials.
The Islamists accuse the military of conducting a brazen coup against Morsi, Egypt's first democratically elected but divisive president, following massive protests calling for his ouster.
Army chief General Abdel Fattah al-Sisi announced Morsi's overthrow on Wednesday night, citing his inability to end a deepening political crisis, as dozens of armoured personnel carriers streamed onto the streets of the capital.
Military police have since arrested Brotherhood supreme leader Mohammed Badie "for inciting the killing of protesters", a security official told AFP.
Former supreme guide Mahdi Akef was also arrested, state television reported.
Morsi himself was "preventively detained" by the military, a senior officer told AFP hours after his overthrow, suggesting he might face trial.
A judicial source said the prosecution would on Monday begin questioning Brotherhood members, including Morsi, for "insulting the judiciary". Thirty-five of them have been banned from travel.
But controversial public prosecutor Abdel Meguid Mahmud said Friday he was to resign, days after being reinstated, citing possible conflicts of interest in future prosecutions.
Morsi's supporters argue the president was confronted at every turn with a hostile bureaucracy left over by former strongman Hosni Mubarak, overthrown in the country's 2011 uprising.
His rule was marked by a spiralling economic crisis, shortages of fuel and often deadly opposition protests.
US President Barack Obama said he was "deeply concerned" over the developments, but refrained from calling the military intervention a coup.
In May, Washington approved $1.3 billion in military aid to Egypt. That was now under review, said Obama, as he called for a swift return to democratic rule.
The African Union suspended Egypt from the bloc in response to Morsi's ouster, after governments across the Middle East welcomed the military's intervention in varying degrees, with war-hit Syria calling it a "great achievement".
Anti-Mosri camp calls for protests
A coalition opposed to ousted Egyptian president Mohamed Morsi called for mass protests Friday to "protect the revolution" after supporters of the deposed Islamist leader took to the streets to defend him.
The National Salvation Front — a grouping of liberal and leftist groups — urged "all Egyptians to mobilise in Egypt's squares and support the June 30 revolution," which saw millions flood the streets to demand Morsi's resignation.
Israel welcomes Morsi's ouster
Meanwhile, Israel is relying on the Egyptian army to suppress Islamist militants in the Sinai and to ensure the country's stability after the dismissal of Mohamed Morsi as president, Israeli media and politicians said.
Ministers in the Israeli cabinet have so far stuck to Prime Minister Benjamin Netanyahu's order for silence on the subject.
But MP Tzahi Hanegbi, who is close to Netanyahu, welcomed the ouster of Morsi, Egypt's first democratically-elected president who hails from the Muslim Brotherhood.
"Israel's clear interest is for Egypt to remain stable, favourable to the West and the US, and that it does not let itself get carried away by a wave of religious extremism," said Hanegbi, former head of the Knesset (parliament) commission on defence and foreign affairs.
"Over Morsi's year in power, we noticed worrying developments, and that is why the return to prominence of the army and a secular authority capable of ensuring the stability of the country is good news for Israel," he added.
Israel's former ambassador to Egypt, Yitzhak Levanon, also stressed the positive role of the army in Egypt.
"The Egyptian authorities are aware of Israel sensitivity to everything that happens in the Sinai, and now the Egyptian army feels a little freer to act firmly against Islamist elements," he explained.
The daily Yediot Aharonot said that the "security cooperation" between the two countries has been beefed up in recent days.
The newspaper reported that just several hours after Morsi's dismissal, an "official Israeli representative secretly arrived in Cairo to meet with Egyptian security and intelligence officials," without giving any further details.
"Security links were good during the Morsi period, and should be even better from now on," Yediot Aharonot wrote.
A hive of militant activity, Egypt's Sinai peninsula is a major route for drugs smuggling and human trafficking.
Ever since the uprising that ousted Hosni Mubarak in 2011, throwing his feared security services into disarray, the region has grown even more restless and awash with weapons.
Attacks and kidnappings targeting Egyptian security forces in the area have multiplied, and militants have fired rockets from the region at Israel.
On Friday, militants launched coordinated rocket and machine gun attacks on Egyptian army and police checkpoints in the Sinai, killing one soldier and wounding two others, Egyptian medical sources said.
A police station and a military intelligence building in the border town of Rafah also came under fire from rockets, security sources said.
Several Islamist militants have publicly threatened to carry out raids in reprisal for Morsi's dismissal on Wednesday.
The Israeli army said Tuesday that it had "authorized" the deployment of Egyptian military reinforcements in the Sinai.
"The Egyptian military activity in the Sinai is coordinated with Israeli security elements and authorized at the most senior levels in Israel, in order to contend with security threats in the Sinai that pose a threat to both Israel and Egypt," the army said in a statement.
The 1979 peace treaty between the two countries has imposed strict controls on deployments.
Oded Granot, a commentator for public television, also stressed that the Egyptian army "has every chance of staying at the centre of the political spectrum".
He noted that "it will be a long time before an Egyptian leader can imitate (Turkey's Islamist prime minister) Recep Tayyip Erdogan, who managed to bring the Turkish army into line".
Another analyst, Udi Segal, said that an Egyptian army "in a strong position" should continue to pursue a policy hostile to the Hamas rulers of the Gaza Strip by blocking the many tunnels between Gaza and Egypt "to prevent Palestinian Islamist militants from infiltrating Egypt".
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