Australia has reversed a decision made four years ago to recognise West Jerusalem as the capital of Israel.

Foreign Minister Penny Wong said the 2018 move had undermined peace and "put Australia out of step with the majority of the international community".

She stressed that Australia remained a "steadfast friend" to Israel. Its embassy will stay in Tel Aviv.

Israel's government called the U-turn short-sighted and deeply disappointing, and summoned the Australian ambassador.

"In light of the way in which this decision was made in Australia, as a hasty response to an incorrect report in the media, we can only hope that the Australian government manages other matters more seriously and professionally," Israeli Prime Minister Yair Lapid said in a statement.

"Jerusalem is the eternal and united capital of Israel and nothing will ever change that."

But Palestinian Prime Minister Mohammed Shtayyeh welcomed the "wise and bold decision", which he said expressed "Australia's respect and alignment with the values of truth, justice and freedom, and the legitimate rights of the Palestinian people, sanctioned by international legitimacy".

The status of Jerusalem is one of the most sensitive issues at the heart of the Israeli-Palestinian conflict.

Then-US President Donald Trump drew international criticism in December 2017, when he reversed decades of American foreign policy by recognising the ancient city as Israel's capital. The US embassy was relocated from Tel Aviv to Jerusalem in May 2018.

Months later, Australia's then-Prime Minister Scott Morrison announced his government would follow suit.

At the time, Mr Morrison said Australia would recognise West Jerusalem immediately but not move its embassy from Tel Aviv until a peace settlement was achieved.