Libyan retaliated by blocking two Swiss businessmen from leaving its territory while Switzerland imposed visa restrictions on some Libyans, effectively blocking them from entering Europe's Schengen 25 nation travel zone.
But the row reached new heights this week when Kadhafi called for jihad against the Alpine state over a recent Swiss ban on the construction of minarets.
Hasni Abidi, the director of the Geneva-based Study and Research Centre for the Arab and Mediterranean World, said the ongoing tussle with Libya was "bad publicity for the Swiss in the Arab and Muslim world," where Switzerland had traditionally played a role in mediation.
Bern was a middleman in ending decades of hostility stemming from World-War I-era massacres between Turkey and Armenia, leading them to sign historic protocols establishing diplomatic ties.
Switzerland also represents US interests in Iran and Tehran's interests in Egypt.
However, "this speciality is very certainly weakening given the situation linked to the Libyan crisis," added another analyst, Frederic Esposito, from the European Institute of the University of Geneva.
Abidi added that this was amplified by a Swiss referendum vote last year to ban the construction of new minarets, a move that drew worldwide criticism and which Kadhafi seized on to call for jihad.
Kadhafi knew that Switzerland's role as a mediator is "based on its image of neutrality and impartiality and openness," said Abidi, and therefore he has attacked this image.
Swiss handling of the Libyan crisis has exposed broader weaknesses in its foreign policy, said analysts.
"The Libyan case has especially hurt the foreign policy of Switzerland... as it has showed an incapacity of managing major dossiers," said Esposito.
That raised questions about its ability to act as a mediator in major international issues.
The analyst however, noted that Switzerland had cleverly played on its Schengen connections to get Libyan attention.
"Switzerland has used very powerful leverage today and I think has won some respect from Kadhafi," said Esposito.
"It's a rather strong element in the negotiation," he added, suggesting that Kadhafi's reaction indicated that the Swiss move had struck a raw nerve.
Abidi also described the move as a "trump card" for Switzerland, but he added that Bern had taken a "risk" in using it.
But for Marcelo Kohen, Professor of International Law at the Graduate Institute in Geneva, the move would have consequences for the Alpine state.
"Switzerland has reacted without measuring the consequences of its action. It should not have used Schengen as a political tool," said Kohen.
"The EU is now to be subjected to the consequences of what should have remained a bilateral affair," he told AFP.
As a result, neutral Switzerland may one day have to repay this favour to its neighbours in the European Union.
"Switzerland has put itself in a situation in which it must now give favours to Europeans. In diplomacy, everything has a cost. No one gives away favours for free," he said.
"In the current difficult situation Switzerland has with its neighbours, it is unfortunate."
Those neighbours have been pressing Switzerland over its banking secrecy rules, which critics claim help to shield tax cheats, Esposito underlined.
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