My guess is that South Korea won't back down because they are highly resolved; South Korea's decision to threaten sanctions despite anticipating North Korea's response beforehand indicates their high resolve. In addition, with local and provincial elections coming up, backing down from their threat would incur audience costs.
Whether or not North Korea backs down is less clear. On one hand, you could argue that North Korea has a history of rhetorical responses thus they could be just bluffing. On the other hand, with North Korea's recent domestic problems and instability such as the failed currency reform and rumors of Kim Jong-il's health issues, Kim may want to show a more hard-line approach.
To assess and predict whether this dispute escalates or not, a more sophisticated argument that incorporates extended immediate deterrence may be needed. Right now the US and Japan seem to be willing to back up South Korea. Therefore, North Korea will need to consider the costs of facing the two states when deciding whether to follow through its threat. China's position is less clear. China has defended North Korea in they past, but currently they are only urging restraint by both sides. Without the backing of China, escalation would less likely be a success for North Korea.
Finally, you could also challenge the unitary actor assumption and say that perhaps, hypothetically, Kim Kong-il's regime has weakened to a point that he doesn't have full control of his military. Military Hawks may be behind the torpedo attack and when North Korea really gets sanctioned, they may press for military escalation or even start a coup. However, it's highly unlikely that we'll be able to get information to confirm this explanation.
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