Australia has become one of the few countries to formally recognise West Jerusalem as Israel’s capital, but says it will not move its embassy from Tel Aviv until a peace settlement is reached.

The prime minister, Scott Morrison, said the government will also recognise a future state of Palestine with its capital in East Jerusalem after a settlement has been reached on a two-state solution.

The foreign policy shift on West Jerusalem was announced by Morrison during his speech to the Sydney Institute on Saturday.

The opposition leader, Bill Shorten, said the government’s decision was a “humiliating backdown” from a rushed byelection announcement and accused the prime minister of putting “his political interest ahead of our national interest”. His comments were echoed by Labor’s foreign affairs spokeswoman, Penny Wong, who described it as a “reckless move” and said Morrison was trying to save face.

On Saturday evening Wong released a statement describing the move as “all risk and no gain” and tweeted: “Labor does not support unilateral recognition of Jerusalem as the capital of Israel and in government would reverse this decision. The status of Jerusalem can only be resolved as part of any peace negotiations and two-state solution.”

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Last week Palestinian leaders were lobbying Arab and other Muslim states to drop Australian exports and withdraw their ambassadors from Canberra in the event of an embassy move to Jerusalem.

While the government has delayed the more controversial embassy relocation, Australia will establish a defence and trade office in Jerusalem and start looking for an embassy site.

Morrison said in his speech on Saturday: “The Australian government has decided that Australia now recognises West Jerusalem – as the seat of the Knesset [Israel’s parliament] and many of the institutions of government – is the capital of Israel. And we look forward to moving our embassy to West Jerusalem when practical, in support of, and after, final-status determination.”

He said neither the Israelis nor the Palestinians viewed the other as a genuine partner for peace.

“Though, a two-state solution remains the only viable way to resolve the Israeli-Palestinian dispute,” he said. “The obstacles, we must admit, to achieving such a solution are becoming insurmountable. We hope not. The lapse of time and the failure to progress the negotiations I believe has changed this Israeli-Palestinian situation in recent times. A rancid stalemate has emerged.

“Slavish adherence to the conventional wisdom over decades appears only to be further entrenching the stalemate, providing for everyone just to keep doing what they were doing and looking the other way … that’s not the way I deal with problems.”

Morrison also accused the United Nations of antisemitism, saying: “We regard the biased and unfair targeting of Israel in the UN general assembly in particular, as deeply unhelpful to efforts to build peace and stability. The UN general assembly is now the place where Israel is bullied and where antisemitism is cloaked in the language of human rights.”

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 Trump unilaterally moved the US embassy there earlier this year.

The relocation was condemned by US allies, Palestinian leaders and the Muslim world. It sparked massive protests in Gaza which resulted in the deaths of 58 Palestinians. Ever since Donald Trump’s declaration in December last year, Israel has been pushing hard to persuade other countries to follow.

On Saturday the president of the Australia Palestine Advocacy Network, Bishop George Browning, said Morrison’s announcement was “a tortuous attempt to salvage himself from a pre-emptive thought bubble prior to the Wentworth byelection”.

The embassy move idea was first floated by Morrison in October in the week leading up to the byelection in Wentworth – an electorate where 12.5% of the population is Jewish, according to the 2016 Census. The byelection was ultimately won by Kerryn Phelps, who beat Liberal candidate Dave Sharma, who is not Jewish but was a former ambassador to Israel.

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“The best one can say is [Morrison’s] announcement is not as catastrophic as many feared,” Browning said. “The problem with it is that it ignores the reality that Israel has passed a new state law which declares Jerusalem to be Israel’s eternal and undivided capital.

“In other words Australia may somewhat pompously say it is all fine, we are only moving into West Jerusalem – Israel considers Jerusalem to be undivided. If the prime minister’s words are to have any meaning he and Australia will need to be far more proactive – if necessary through sanctions and boycotts – to pressure Israel into a genuine commitment to peace and the recognition of Palestinian rights, specifically in East Jerusalem.”

But the announcement was described as a “positive step forward” by chair of the Australia-Israel Parliamentary Group, the Tasmanian Liberal senator Eric Abetz.

“Clearly the status quo of sitting back has not worked for the last 20 years and the government’s decision to be more actively involved especially at a time when the United Nations has been stepping up its biased attacks against Israel is positive,” Abetz said.

In a series of tweets on Tuesday, senior Palestinian official Saeb Erekat urged the Australian government to “stay the course with international law and agreements signed between Palestinians and Israelis”. On Tuesday morning, Erekat wrote: “I call upon all Arab and Muslim countries to sever all relations with with Australia, if it recognises Jerusalem as Israel’s capital,” adding that Arab and Muslim countries had adopted a resolution to cut ties with any country to do so.

There are serious concerns Morrison’s announcement could have trade implications, with Saudi Arabia the largest importer of live meat from Australia, and that it could also jeopardise the signing of a critical free-trade deal with Indonesia. In October Malaysia warned moving the embassy could fuel terrorism.

In October, the former deputy prime minister, Barnaby Joyce, warned the government has “got to be careful” around Israel policy, because many countries that import Australian agricultural exports including Indonesia, Qatar, Saudi Arabia, Bahrain and Jordan have “lots of sensitivities here”.

In October, Australia’s spy agency Asio warned any embassy move may “provoke protest, unrest and possibly some violence in Gaza and the West Bank”.

In a statement on Saturday, Ross B Taylor, the president of the Perth-based Indonesia Institute Inc, said it “[remained] to be seen” how the Indonesian government would respond to Morrison’s announcement. “Almost certainly there will be anti-Australian protests, but whether Indonesia will announce a more severe response is unknown at this stage.”

Taylor added: “Given that both Morrison and Indonesia’s president Joko Widodo will face robust elections in early-mid 2019 – during which time their respective hardline conservatives are now pushing hard for their leaders to show strength on the issue of Jerusalem – it was folly for Australia’s prime minister to even raise the issue at this time, as it was always going to ‘wedge’ both leaders, with no satisfactory outcome.”

On Saturday the Australian Greens leader, Richard Di Natale, described Morrison’s announcement as “irresponsible” and “another body blow for the peace process and for the Palestinian people”.

“The best way to advance the prospect of peace in Israel and Palestine is to recognise a Palestinian state … The fact that [Morrison] has refused to back down in the face of overwhelming criticism, including from his own hand-picked advisory panel, is Trumpesque in its stupidity,” Di Natale said.

The former prime minister Kevin Rudd tweeted on Saturday that Morrison’s announcement was “A politically craven decision by a failing prime minister to appease Netanyahu’s far right Israeli govt & far right lobby in Oz. A reminder: this is the same Netanyahu who presided over forging Oz passports for use in Mossad’s 2009 assassination in Dubai.”

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In October, Morrison said he was “open to” the embassy move, describing it as a “sensible” proposal. An evangelical Christian, Morrison immediately faced questions about whether his religious views had played a part in his decision to float the proposal. “My faith and religion has nothing to do with this decision,” he said.

The government said the embassy proposal was flagged due to a vote on the UN general assembly resolution on the Palestinian Authority chairing the G77. But the byelection in Wentworth, once held by ousted PM Malcolm Turnbull, was also widely considered a factor.

Phelps said at the time the policy was nothing more than “a politically motivated move”.

“To announce [the embassy move] without bipartisan discussion, without comprehensive analysis of the defence, security and trade implications, this should not have been raised in the context of the byelection,” she said.

On Saturday a spokeswoman for Jews Against the Occupation Sydney, Vivienne Porzsolt, said Morrison’s move to recognise West Jerusalem as the capital without immediately moving the embassy was “a welcome backdown from an ill-considered proposal announced in the heat of a byelection”.

“It would have had disastrous consequences and rightly was condemned on all sides,” she told Guardian Australia.

“However, it would be much more relevant to immediately recognise Palestine which hopefully the national conference of the ALP this week will adopt as policy.

“The continuing alignment of Australia with the Israeli government and its extreme rightwing policies and the proposed build-up of mutual trade and ‘defence’ relationships is a serious barrier to a just peace and an end to the Israeli occupation with its continuing murders, dispossession and total denial of the rights of the Palestinians.”

Also in his speech on Saturday, Morrison spoke about the Iran nuclear deal, which he has previously said he was open to reviewing.

“Our concerns about Iran relate not to what’s in the agreement but what’s not in the agreement,” he said. “The agreement does not address Iran’s destabilising activities in the Middle East and beyond. It does not address Iran’s proliferation of ballistic missiles and technology, and support for terrorist groups. These are activities that the global community must act on.”

Australian Associated Press contributed to this report