Environment minister Avi Gabbay announced his resignation in a strongly worded statement that accused Netanyahu of putting the country on a path to ruin.
Gabbay said that he was "unable to swallow" Netanyahu's decision to take the defence portfolio from former general Moshe Yaalon and hand it to Avigdor Lieberman, who has pledged harsh measures against Palestinian "terrorists".
Yaalon resigned from the government a week ago in protest, warning of a rising tide of extremism in the party and the country as a whole.
"I could not accept the removal of Yaalon, a professional and thoughtful defence minister," Gabbay said.
"The country of course has the right to have a government of the right or left," he added. "But I do not think it is right... to form an extremist government."
"We must stop the process which I fear will lead to our ruin."
Gabbay, of the centre-right Kulanu party, is not a member of parliament and his resignation does not affect the ruling rightwing coalition's majority.
Yaalon himself was quick to praise Gabbay for his stand.
"In our politics, sticking to principles has become an object of ridicule, while U-turns and deceit are considered 'sophisticated'," he wrote on Twitter in Hebrew.
"Full appreciation to Avi Gabbay who proves that another way is possible. One must not give up."
Co-opting Lieberman and his Yisrael Beitenu party will add five lawmakers to Netanyahu's previously wafer-thin majority if the coalition deal is given parliamentary approval next week as expected.
In his announcement, Gabbay referred to the frosty relations between Netanyahu and US President Barack Obama.
"COMPLETELY MESSED UP"
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"It wasn't easy for me being a member of this government... which completely messed up relations with the most important power in the world, which preserves our security interests."
The United States has said that the new coalition raises "legitimate questions" about the Netanyahu government's commitment to a two-state solution with the Palestinians.
US State Department spokesman Mark Toner, in a rare comment on Israeli internal politics, said Wednesday that Washington had "seen reports from Israel describing it as the most right-wing coalition in Israel's history".
"And we also know that many of its ministers have said they oppose a two-state solution," he said.
Netanyahu says he still plans to pursue peace with the Palestinians -- though negotiations have been at a standstill since April 2014.
The Palestinians said Wednesday that Lieberman's appointment jeopardises regional stability.
"The existence of this government brings a real threat of instability and extremism in the region," Palestinian chief negotiator Saeb Erekat told AFP, adding that the move would "result in apartheid, racism and religious and political extremism."
In 2001, Lieberman advocated bombing the Aswan Dam in Egypt, accusing Israel's Arab neighbour of supporting a Palestinian uprising.
More recently he said that the leader of the Islamist movement Hamas in the Gaza Strip, Ismail Haniya, had 48 hours to hand over two detained Israeli civilians and the bodies of soldiers killed in a 2014 war "or you're dead".
As defence minister, Lieberman, who himself lives in a Jewish settlement in the occupied West Bank, would oversee military operations in the Palestinian territories and have a major say in policy towards the settlements.
The defence portfolio is widely seen as the second-most powerful in the government, overseeing an array of contracts, missions and activities in a country on a near-constant war footing.
Former Labour prime minister and defence minister Ehud Barak said after Yaalon's resignation that Israel's government "has been infected by the shoots of fascism".
"Sooner or later we shall see the cost and can only pray that we shall not have to pay too high a price," he told Israel's Channel 10 TV.