The hosts reached 76-1 at the close as 16 wickets fell on day three in Manchester.
England, resuming on 152-4, capitulated meekly and were bowled out for 202 with Daniel Vettori claiming 5-66 to surrender a first innings deficit of 179 runs.
But then left-arm spinner Panesar, who claimed his 100th Test victim before the tea interval, spearheaded the fightback as he helped dismiss New Zealand for 114 in their second innings
Vettori removed Alastair Cook late on but Andrew Strauss (23) and Michael Vaughan (12) saw England through to the close and they need a further 222 runs for victory.
The highest fourth innings total to win a Test at Manchester is currently 231 by England against West Indies in 2004.
England, at 180-9, were still two runs short of avoiding the follow-on before Stuart Broad, who registered England's only boundaries of the morning, took them over the threshold.
Kevin Pietersen (26) edged one to Ross Taylor at slip, Ian Bell (8) then edged Iain O'Brien to second slip where Taylor took the catch after a juggle and Paul Collingwood (2) was trapped lbw by Vettori after the ball struck him on his back leg.
Tim Ambrose (3) gave Taylor his third catch with an edge to slip off Vettori and Panesar (1) edged Kyle Mills to Brendon McCullum, who took a spectacular, diving, one-handed catch before Broad was the last man out for 30.
But Panesar also exploited a pitch that offered considerable bounce and turn as New Zealand's batsmen struggled to master his bowling.
He removed Jamie How (29), James Marshall (28), Brendon McCullum (0), Ross Taylor (15) all lbw and had Vettori (4) and Kyle Mills (8) caught as they attempted to sweep.
James Anderson had removed Aaron Redmond early on but the Kiwis were 50-1 before their demise with Ryan Sidebottom chipping in with the wickets of the ailing Jacob Oram and O'Brien with Daniel Flynn unable to bat.
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