The banner, which also featured the insignia of far right group United Patriots Front, was eventually taken down and the fans responsible removed from the ground by stewards.
AFL chief Gillon McLachlan said in a statement on Saturday that the banner displayed at the game between Collingwood, who are nicknamed the Magpies, and Richmond was "divisive, ignorant and deeply offensive".
"Our game has a history of egalitarianism and inclusion, and we must make sure that it continues to be a place where all Australians feel welcome," he added.
"The sentiment on that banner, and the use of our game to push divisive and ignorant commentary will be rejected by our supporters and our clubs."
Islam is the third largest religious grouping in Australia with around 500,000 adherents in a population of more than 23 million.
Collingwood president and TV host Eddie McGuire, who was involved in racism row in 2013 over a joke he made about indigenous player Adam Goodes, said the fans responsible should be banned for life.
"We're sick to death of people using the Collingwood Football Club and the AFL to (promote) absolute vile hatred," he told reporters on Saturday.
"We're all sick of it and we've had enough and we're appalled by it."
The AFL, Australia's most financially successful professional football league, was embroiled in a racism debate which convulsed the nation over the booing of Goodes, a former Australian of the Year.
The barracking of Goodes started after he called security on a 13-year-old female Collingwood fan who called him an "ape" during a game in 2013.
McGuire condemned the remark and apologised to Goodes on Collingwood's behalf but later the same week admitted to "inadvertently" racially vilifying the player with a joke on a radio show.
(Reporting by Nick Mulvenney; Editing by John O'Brien)
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