The left-arm spinner, who has rapidly gained cult status among England fans, took five for 72 as Pakistan, 342 runs behind after the first innings, were dismissed for 222 in the final session of the day at Old Trafford.
Strike bowler Steve Harmison, who took a remarkable six for 19 in the first innings, swept away the lower order with five for 52 and claim the first 10-wicket haul of his Test career.
No other England bowler took a wicket in the entire match.
The 24-year-old Panesar, turning the ball sharply and extracting surprising bounce, snared Pakistan's key men, Mohammad Yousuf (15) and skipper Inzamam-ul-Haq (13), in the space of three overs in the afternoon before adding vice-captain Younis Khan (62) to his list of victims.
He got Yousuf for the second time in the match and the third time in three innings with the first ball after lunch.
Yousuf, who had saved Pakistan in the first Test with a double century, was lured forward and beaten by the spin, leaving his back toe on the line just outside his crease as Geraint Jones neatly clipped off the bails.
Inzamam did not even get that far. He appeared to have survived a barrage from strike bowler Harmison when he fell victim to a wretched piece of luck, dabbing a ball from Panesar down onto his boot and straight to Alastair Cook at silly mid-off.
PANESAR STRIKES
Younis, unsettled by Panesar's spin with one delivery even spinning past both the edge and the wicketkeeper straight to first slip, fatally opted to pad up to an arm ball and went lbw.
The players returned from an early tea provoked by light rain and Panesar, cheered on by his personal fan club of 17,000 people, immediately returned to centre stage with a classic left-armer's dismissal.
Faisal Iqbal (3) pushed forward to a ball pitching on his leg stump, the ball zipped off the surface and the edge carried to a delighted Marcus Trescothick at first slip to make it 174 for six.
Harmison then barged back into the picture, chipping in with two wickets in three balls and three wickets for four runs. Shahid Afridi snicked behind after a cameo run-a-ball 17 and Mohammad Sami slogged wildly and went in similar fashion for a senseless duck before the innings ended.
Harmison had broken through in the morning with a brute of a delivery to dismiss Kamran Akmal (4) after Pakistan resumed on 12 without loss.
The ball cut in off the seam and reared towards Akmal's throat before being pouched off the glove by Geraint Jones.
Panesar, replacing the struggling Matthew Hoggard at the Brian Statham End, then struck in his fourth over with the wicket of the left-handed Imran Farhat -- like Geraint Jones playing with a finger fracture after hurting himself on Friday.
Flicking at a full-length ball, he inside-edged onto his pad and into Ian Bell's hands at short leg to depart for a duck.
England now lead the four-match series 1-0 with the next game starting at Headingley in Leeds on Friday, Aug. 4.
