Australia now recognises west Jerusalem as Israel's capital, Prime Minister Scott Morrison said on Saturday, but a contentious embassy shift from Tel Aviv will not occur until a peace settlement is achieved.
Canberra became one of just a few governments around the world to follow US President Donald Trump's lead and recognise the contested city as Israel's capital, but Mr Morrison also committed to recognising a future state of Palestine with east Jerusalem as its capital.
"Australia now recognises west Jerusalem — being the seat of the Knesset and many of the institutions of government — is the capital of Israel," Mr Morrison said in a speech in Sydney.
Both Israel and the Palestinians claim Jerusalem as their capital.
Most foreign nations avoided moving embassies there to prevent inflaming peace talks on the city's final status — until Mr Trump unilaterally moved the US embassy there earlier this year.
"We look forward to moving our embassy to west Jerusalem when practical, in support of and after the final status of determination," Mr Morrison said, adding that work on a new site for the embassy was underway.
In the interim, the prime minister said, Australia would establish a defence and trade office in the west of the holy city.
"Furthermore, recognising our commitment to a two-state solution, the Australian government is also resolved to acknowledge the aspirations of the Palestinian people for a future state with its capital in east Jerusalem," he added.
Mr Morrison first floated a shift in foreign policy in October, which angered Australia's immediate neighbour Indonesia — the world's most populous Muslim nation. The issue has put a halt on years-long negotiations on a bilateral trade deal.
Canberra on Friday told its citizens travelling to Indonesia to "exercise a high degree of caution", warning of protests in the capital Jakarta and popular holiday hotspots, including Bali.
Mr Morrison said it was in Australia's interests to support "liberal democracy" in the Middle East, and took aim at the United Nations he said was a place Israel is "bullied".
The Jerusalem decision could help the embattled Australian Prime Minister - who faces the prospect of an election drubbing next year — with Jewish and conservative Christian voters and win him friends in the White House.
The opposition Labor party slammed Mr Morrison for putting "self-interest ahead of the national interest".
"Recognising West Jerusalem as Israel's capital, while continuing to locate Australia's embassy in Tel Aviv, is nothing more than a face saving exercise," shadow minister for foreign affairs Penny Wong said in a statement.
"This is a decision which is all risk and no gain," she said, adding it puts Australia "out of step" with the international community.
Mr Trump's decision to move the US embassy from Tel Aviv last May prompted tens of thousands of Palestinian protesters to approach the heavily-protected Israeli border. At least 62 Palestinians were killed by Israeli fire that day.
Israeli Prime Minister Benjamin Netanyahu has previously hailed Mr Morrison's initiative.
The Palestinian government will press for Arab and Muslim states to "withdraw their ambassadors" and take some "meat and wheat" style "economic boycott measures" over Canberra's decision, Palestinian ambassador to Australia Izzat Abdulhadi told AFP Friday.
The Australia Palestine Advocacy Network (APAN) on Saturday said Mr Morrison's move "serves no Australian interest".
"This sabotages any real possibility for a future just agreement and further emboldens Israel to continue with its daily human rights violations of Palestinians," APAN president Bishop George Browning said in a statement.