Last week Attorney-General George Brandis told Senate Estimates that Australia would drop "occupied" when referring to East Jerusalem.
Australia is the only nation apart from Israel to change its language on the contested land.
"Australia [will] isolate itself from the entire international community, and from the peace process," Ambassador to the General Delegation of Palestine, Izzat Abdulhadi, told SBS.
The Ambassador has met with counterparts from Arab and Asian nations to draft a letter calling for an urgent meeting with Foreign Minister Julie Bishop to clarify Australia's position.
"In this letter we express our deep concern about this position of Australia," Mr Abdulhadi says.
"We think it's important for Australia to revise its position."
Israeli Ambassador to Australia, Schmuel Ben-Schmuel, has welcomed the policy shift.
"It's a reasonable step which I wish all like-minded countries would accept," Mr Ben-Schmuel told SBS.
The Ambassador says the change will help the peace process.
"The way through peace is through direct negotiation through the parties involved."
Former Australian Ambassador to Israel, Ross Burns, disagrees.
"Now we seem to be losing our capacity to dialogue with the Arab side," the ex-Ambassador turned Palestinian advocate, says.
"Our name has been mud, particularly among the Palestinians, but also generally in the Arab world."
Some commentators think the decision to drop "occupied" is less about the federal government's ideology, and more about keeping the Jewish lobby happy.
"They're trying to do this as some kind of quid pro quo in relation to the Racial Discrimination Act," Independent journalist and author Antony Loewenstein says.
Representatives of the Israeli community in Australia refute that.
"It's irrelevant," Colin Rubenstein from the Australia/Israel and Jewish Affairs Council says.
"It's completely unrelated to that."
Foreign Minister Julie Bishop issued SBS with a statement saying there's been no change to the federal government's position on the legal status of the Palestinian Territories.
The Palestinian Authority has summoned Australian representative in Ramallah, Tom Wilson, to issue a please explain.
Dr Saeb Erekat, a senior member of the Palestinian Authority, has written to Minister Bishop saying that the Arab League and the Organisation of Islamic Cooperation may review their relations with Australia in light of the policy shift.
