Australia's Muslim-majority neighbour Malaysia has said it "strongly opposes" the decision to recognise West Jerusalem as the capital of Israel.

The announcement was "premature and a humiliation to the Palestinians and their struggle for the right to self-determination," the Malaysian government said in a statement on Sunday, advocating a two-state solution to the Israeli-Palestinian conflict.

Earlier, Australia's immediate neighbour Indonesia - the world's most populous Muslim nation - was angered by a proposal to move the Australian embassy to Jerusalem, which has since been shelved. The country said on Saturday it "notes" the decision.

Despite the criticism, Australian Prime Minister Scott Morrison has stood by the decision.

Citing Jakarta's response, Morrison said on Sunday that the international reaction had been "measured" and that his decision would progress a two-state solution. 
      
"I think the responses that we have seen from countries so far has been measured," Morrison told reporters in Canberra.

"Australia would continue to respect a two-state outcome that remained our goal as strongly as ever."

Morrison first floated a shift in foreign policy in October, which angered Indonesia. The issue has put a halt on years-long negotiations on a bilateral trade deal.

'All risk and no gain'

However, Morrison said on Saturday that the embassy shift from Tel Aviv will not occur until a peace settlement is achieved.

With the embassy move delayed, Morrison said that his government will establish a defence and trade office in Jerusalem, while work on the new site for an embassy is under way.

The Israeli embassy in Canberra on Sunday said the decision was a "step in the right direction".

"Israel congratulates the Australian government for its stance regarding sanctions on Iran," it said in a statement.

"Israel also welcomes the Australian government's pro-Israel position at the United Nations as well as its principled stance against anti-Semitism."

The status of Jerusalem is one of the main sticking points in negotiations between Israel and the Palestinians.

Israel regards the whole city, including the eastern sector it unilaterally annexed after the 1967 Middle East war, as its capital while Palestinian officials, with broad international backing, want occupied East Jerusalem as the capital of a future state they hope to establish in the occupied West Bank and the Gaza Strip.

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 earlier this year.

Australia's opposition Labour Party said the prime minister's decision had been "reckless".

"Recognising West Jerusalem as Israel's capital, while continuing to locate Australia's embassy in Tel Aviv, is nothing more than a face-saving exercise that shows Mr Morrison continues to put self-interest ahead of the national interest," shadow minister for foreign affairs Penny Wong said in a statement.

"This is a decision which is all risk and no gain. It is a reckless move by a desperate and divided government that satisfies no one."