The party's factions reached the deal on the wording of a resolution on the issue, but ditched plans to alter the ALP's policy platform at the its national conference on Sunday.
"If ... there is no progress in the next round of the peace process a future Labor government will discuss joining like-minded nations who have already recognised Palestine and announcing the conditions and timelines for the Australian recognition of a Palestinian state, with the objective of contributing to peace and security in the Middle East," it said.
Israeli ambassador Shmuel Ben-Shmuel watched on as intense negotiations took place on the conference floor for more than an hour in the lead up to the vote in Melbourne.
Ultimately, a joint Right-Left resolution - reflecting compromise after each faction put up separate motions - passed on voices.
Federal frontbencher Tony Burke, from the Right, acknowledged there would never be a set of words that pleased everybody.
"This resolution will disappoint anybody who believes that (peace) negotiations should go on forever," he told the conference.
"This will also disappoint anyone who wants unilateral recognition for Palestine tomorrow."
The compromise recognises any resolution of the Palestinian situation should be based on 1967 borders with agreed land swaps, a timeframe to end Israeli occupation, demilitarisation of Palestinian territory, agreement on a solution to Palestinian refugee issues and resolution of the issue of Jerusalem's final status.
It also recognises settlement building by Israel in the Occupied Territories may undermine a two-state solution and calls for Israel to stop all such settlement expansion to support renewed negotiations toward peace.
Mr Burke said this made clear Labor believed it was unacceptable to delay forever peace talks which have gone on for more than two decades.
Both Israel and Palestine must recognise each had a right to exist, he added.
Left faction figure Wendy Turner, an Australia Palestine Advocacy Network board member, seconded the motion, saying it was a milestone for the ALP.
"Enough is enough," she said.
"It's time, and the right and honourable thing to do; time for action and not words for Australian Labor in government to recognise Palestine."
The conference also rejected the boycotts, divestment and sanctions (BDS) campaign against Israel.
The resolution passed to applause.
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