Palestinians have reacted with shock and dismay to the suggestion Australia could move its embassy to Jerusalem.

Key points: Morrison using short-term, domestic considerations to set foreign policy, senior Palestinian official says

Morrison using short-term, domestic considerations to set foreign policy, senior Palestinian official says Decision sparks surprise and disgust in the Arab neighbourhood next to Jerusalem's Old City

Decision sparks surprise and disgust in the Arab neighbourhood next to Jerusalem's Old City Israeli media report Australia acknowledges East Jerusalem could be future Palestinian capital

While Prime Minister Scott Morrison said the move could advance the Israel-Palestine peace process, Palestinian representatives say Australia's action would sabotage it.

Senior Palestinian official Nabil Shaath said Mr Morrison appeared to be using short-term, domestic political considerations to set his foreign policy.

"Politically, this destroys the chances of peace," Mr Shaath said.

"This doesn't really help, [but] it might increase the chances of the Government winning Wentworth in Australia.

"If this is the way you do politics in the Middle East, in order to win a by-election in Australia, please allow me to be very negative towards the policy of that Australian Government."

There is ongoing dispute over the status of East Jerusalem, the part of the city seized by Israeli forces in 1967 and considered by the United Nations to be under military occupation ever since.

The UN has denounced the building of settlements in the city and attempts to change its demographic composition, ie to move more Jewish people into Arab neighbourhoods and displace Arab residents.

Decision evokes surprise and disgust

In Silwan, the Arab neighbourhood next to Jerusalem's Old City, where recent Jewish settlers and longstanding Arab residents live uncomfortably close to each other, the decision evoked surprise and disgust.

Jawad Syiam runs the Wadi Hilweh Information Centre in Silwan, which monitors the movement of Jewish settlers into Arab neighbourhoods.

"Australia has always given the impression that they are neutral, which was OK with Palestinians," Mr Syiam said.

"But now we see Australia as following the devil, Donald Trump.

"So this is a very stupid decision from a country that wanted to keep away from any attacks, from any problems."

Jawad Syiam at the Wadi Hilweh Information Centre in Silwan. ( ABC News: Eric Tlozek )

Silwan resident Sahar Abbasi said Australia should recognise that Arabs in East Jerusalem — who were mostly "residents" rather than full citizens of Israel — faced ongoing discrimination.

"Don't forget that it's an occupied territory, don't forget the people who are being occupied in this land and those are us Palestinians and actually lately we're being totally ignored, like we don't exist," Ms Abbasi said.

While the Israeli Government welcomed the Prime Minister's comments, the reaction within Israel has been muted, with Israeli media noting that an Australian Government statement acknowledged East Jerusalem could be the capital of a future Palestinian state.

Former Israeli diplomat Lior Weintraub, now the vice-president of advocacy organisation The Israel Project, said that was a sensitive matter in Israel.

"Recognising Jerusalem as the capital of Israel, I think, is very natural and placing the embassy — if you want to avoid any controversy — in a place where under any peace agreement will be part of Israel, is the right approach," Mr Weintraub said.

"Recognising west and east and to start talking about borders, this is very sensitive and delicate, especially at times when unfortunately this track (the peace process) is at an impasse and there's no discussion taking place."

A White House official told the ABC that the US appreciated Australia's stance.

"We welcome and strongly support Australia's review and discussions on relocating its embassy, seeking a better deal with Iran, and increasing engagement with Israel," the official said.

Israel passed a law in 1980 saying the whole of the city of Jerusalem was the country's "complete and united" capital.

That was denounced by the UN Security Council, which said the law breached previous UN resolutions.