Australia's conservative prime minister on Sunday stood by his decision to recognise West Jerusalem as the capital of Israel, despite criticism from neighbouring Muslim countries.

Canberra became one of a handful of governments to follow US President Donald Trump's lead and recognise the contested city as Israel's capital, Prime Minister Scott Morrison had announced Saturday.

But a contentious embassy shift from Tel Aviv — a proposal made during a crucial Sydney by-election that critics said was timed to attract Jewish voters — will not occur until a peace settlement is achieved.

Australia's Muslim-majority neighbour Malaysia said on Sunday it "strongly opposes" the decision to recognise West Jerusalem.

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

Australia's immediate neighbour Indonesia, the world's most populous Muslim nation, was angered by the embassy move proposal in the run-up to the by-election, and said on Saturday it "notes" 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."

Israel's embassy in Canberra on Sunday said the decision was a "step in the right direction".

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 earlier this year.

Morrison's embattled coalition slipped into a minority government after losing the Sydney by-election in October, which followed the Liberal party's ousting of the local member and then prime minister Malcolm Turnbull.