A Palestinian man prays in front of the Dome of the Rock at the Al Aqsa mosque compound in Jerusalem. File/AFP
"We welcome Australia's decision with regards to Jerusalem & its call for a two-state solution in accordance with international legitimacy," the Palestinian Authority's civil affairs minister, Hussein Al Sheikh, said on Twitter.
Sheikh hailed Australia's "affirmation that the future of sovereignty over Jerusalem depends on the permanent solution based on international legitimacy".
Announcing the change of policy by Australia's centre-left government, Foreign Minister Penny Wong said Jerusalem's status should be decided through peace talks between Israelis and Palestinians, and not through unilateral decisions.
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"We will not support an approach that undermines" a two-state solution, she said, adding: "Australia's embassy has always been, and remains, in Tel Aviv."
Israeli Prime Minister Yair Lapid described the policy reversal by Australia's centre-left government as a "hasty response".
"Jerusalem is the eternal and united capital of Israel and nothing will ever change that," Lapid said in a statement released by his office.
In 2018 a conservative government led by Scott Morrison followed then US president Donald Trump's lead in naming west Jerusalem as the Israeli capital.
The move caused a domestic backlash in Australia and caused friction with neighbouring Indonesia — the world's most populous Muslim-majority nation — temporarily derailing a free trade deal.
Jerusalem captured east Jerusalem in the Six-Day War of 1967 and later annexed it in a move not recognised by most of the international community.
The city is claimed by both Israelis and Palestinians, and most foreign governments avoid formally declaring it the capital of any state.
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