The Australian Government will recognise West Jerusalem as the capital of Israel but will not immediately move its embassy from Tel Aviv.

Key points: The Federal Government has announced it will recognise West Jerusalem as the capital of Israel

The Federal Government has announced it will recognise West Jerusalem as the capital of Israel Prime Minister Scott Morrison acknowledged the aspirations of Palestinians for a future state with its capital in East Jerusalem

Prime Minister Scott Morrison acknowledged the aspirations of Palestinians for a future state with its capital in East Jerusalem Palestinians reacted with dismay when Mr Morrison first floated moving the embassy

Prime Minister Scott Morrison announced the foreign policy shift during a speech in Sydney, arguing it was a "balanced" and "measured" position.

"Australia now recognises West Jerusalem, being the seat of the Knesset [Israel's parliament] and many of the institutions of government, is the capital of Israel," Mr Morrison said.

"Furthermore, recognising our commitment to a two-state solution, the Australian Government has also resolved to acknowledge the aspirations of the Palestinian people for a future state with its capital in East Jerusalem."

Mr Morrison delayed moving Australia's embassy from Tel Aviv but said a trade and defence office would be established in West Jerusalem.

"We look forward moving to our embassy to West Jerusalem when practical, in support of and after, final status determination."

He said his decision to weigh into the issue had been mocked but that Australia had earned the right to have its say on the issue.

"When you look at our incredible influence, both in the creation of the state of Israel and our partnership with it over so many years, it's hard to say that Australia's influence has been small. It's been quite great," Mr Morrison said.

"So, while Australia's voice and the megaphone we have is not as great as the great powers — that's true.

"But I've got to say, ever since I raised this issue several months ago, people have been pretty keen to know what we were going to say."

Sorry, this video has expired Previously, Palestinian and Indonesian foreign ministers told Australia to back down on its Israel embassy intentions.

'This sabotages … possibility for a future just agreement'

The Australia Palestine Advocacy Network said it was dismayed by the Prime Minister's plan, which it argued would damage the peace process.

"It serves no Australian interest, will weaken our trade and security relations with regional partners, and may irreparably injure our international reputation by aligning Australia with the Trump and Netanyahu governments against an overwhelming international consensus regarding the status of Jerusalem," APAN's president Bishop George Browning said.

"This sabotages any real possibility for a future just agreement."

The prospect of moving Australia's embassy in Israel prompted Indonesia to delay finalising a landmark free trade agreement. ( AAP: Lukas Coch )

The announcement is being made on the Jewish day of rest, known as the Sabbath, meaning the Executive Council of Australian Jewry is unable to formally respond.

It pointed to a statement from October which said it had long called for Australia to recognise Jerusalem as Israel's capital.

"Every state has the right to determine where within its sovereign territory its capital should be located," it said.

"Jerusalem was the capital of the Jewish state 3,000 years ago and it remains so today. Recognising this simple fact would in no way preclude a future agreement between Israel and the Palestinians and we welcome the Prime Minister's affirmation of support for a two-state solution to the conflict."

Shorten slams move as a 'rookie mistake'

Federal Opposition Leader Bill Shorten described Mr Morrison's decision not to immediately move the embassy as a "humiliating backdown".

"I'm not sure when he rushed the announcement of moving the embassy that he really knew what he was doing," Mr Shorten said.

"I'm tempted to think it was a rookie mistake by an L-plate Prime Minister."

Mr Shorten said a Labor government would reverse the decision to recognise West Jerusalem as Israel's capital.

He said Mr Morrison's handling of the issue had damaged Australia's reputation.

"My fear is that Mr Morrison hasn't just had to do a political backdown, my fear is that he's made Australia look stupid on the international stage."

Mr Morrison, in the final days of the Wentworth by-election, announced he was reviewing whether to recognise West Jerusalem as the capital.

At the time, he denied it was aimed at winning over Jewish voters in the seat which the Government ultimately lost to independent Kerryn Phelps.

Palestinians reacted with shock and dismay at the suggestion of moving the embassy and warned Australia was at risk of becoming an "international pariah".

Top officials from the Department of Foreign Affairs and Trade (DFAT) confirmed in October that they had not been consulted by the Prime Minister before he announced he was contemplating moving the embassy.

The announcement of a review sparked anger in Indonesia and left a major free trade agreement with the country in limbo.

The final deal, which Mr Morrison and Indonesian President Joko Widodo announced in Bali in August, was eight years in the making and was expected to be signed by the end of the year, delivering Australian exporters and the education sector millions of dollars in benefits.

Indonesia has the world's largest Muslim population and is a strong supporter of the Palestinian territories.

After Mr Morrison's announcement, a statement from the Indonesian Foreign Ministry noted Australia's decision to not relocate its Embassy, and called on Australia and all UN member states to promptly recognise the State of Palestine.

A spokeswoman for presidential candidate Prabowo Subianto called Mr Morrison's announcement a "deceitful and suicidal move".

"For people on the street, for a normal Muslim who doesn't follow every detail of the Middle East, they have no idea about the difference between West and East Jerusalem," spokeswoman Dian Fatwa said.

"If Indonesian people are hurt by this issue [because of their support for Palestinian cause] they won't buy Australian cattle, produce and services. Eventually that will hurt Australian farmers."

It remains unclear when the free trade agreement will now be signed.