Foreign Minister Stephen Smith said it was with "sorrow" that Australia took such action against a long-term friend but stressed the passport fraud - part of a murder plot against a Hamas leader in January - was intolerable.
"This is not what we expect from a nation with whom we have had such a close, friendly and supportive relationship," he told parliament.
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An investigation, involving federal police and the nation's key spy agencies, was initiated in March after it emerged Australian passports were used in the killing of senior Hamas official Mahmoud al-Mabhouh in Dubai in January.
Israel has described the action as regrettable, suggesting it failed to recognise the deep and enduring ties between the two countries.
Australia has long been one of Israel's closest friends and the relationship dates back to the creation of a separate Jewish state in the late 1940s.
"We feel it is not reflective of the extensive relationship between the two nations," a spokesman for the Israeli embassy in Canberra said.
Government 'over-reacting'
Deputy Liberal leader Julie Bishop, the coalition's foreign affairs spokeswoman, attacked the government for over-reacting, a sentiment echoed by former foreign minister Alexander Downer.
And she accused the government of taking the decision to try to garner Arab votes in Australia's bid for a temporary seat on the United Nations Security Council.
"I am concerned this is a purely political decision," Ms Bishop told Sky News. "There is no absolute proof that the Israeli government did it."
The expulsion may precipitate some uncomfortable conversations between Canberra and Washington when US President Barack Obama visits Australia later this year.
The US - which received an early alert of Canberra's decision - finds itself in the difficult position of being an ally of Australia, as well as Israel's closest friend.
But Australia is not the only country to take stern action in response to the use of its passports in the murder plot.
Concerns for co-operation
Britain - also involved in the passport scandal, along with France, Germany and Ireland - expelled a diplomat in March.
The government is refusing to disclose details of the expelled diplomat but the online edition of the Haaretz newspaper is reporting that the official is the Mossad representative for the Israeli embassy in Canberra.
Australia admits the relationship will take time to repair following this episode.
Mr Smith acknowledged it could diminish co-operation, particularly in areas of intelligence and security.
"Clearly as a result of today's events there will be something of a cooling-off period so far as relevant agencies are concerned," he said.
He refused to put a timetable on the normalisation of relations.
Trust, confidence damaged
"We would want very much for those cooperative relationships to proceed but there does require a rebuilding of trust and confidence."
He stressed, however, Canberra took no pleasure from the turn of events.
"This decision is made much more in sorrow than in anger," he said.
It has sparked an outcry from the Israeli community in Australia, generally a strong supporter of the Australian Labor Party.
And it could create headaches for the government in tight inner urban seats with big Jewish communities.
The Executive Council of Australian Jewry warned little good would come from taking punitive action against Israel, while the Australia-Israel and Jewish Affairs Council described the move as unhelpful.
