A semiconductor device has semiconductor die mounted to a temporary carrier. An encapsulant is deposited over the die and carrier. A channel is formed in a back surface of the die, either while in wafer form or after mounting to the carrier. The channel corresponds to a specific heat generating area of the die. The channel can be straight or curved or crossing pattern. The carrier is removed. An interconnect structure is formed over the encapsulant and die. The semiconductor die are singulated through the encapsulant. A TIM and heat sink are formed over the channel and encapsulant. Alternatively, a conformal plating layer can be formed over the channel and encapsulant. A conductive via can be formed through the encapsulant, and TSV formed through the die. The die with channels can be mounted over a second semiconductor die which is mounted to the interconnect structure.