The match, held in the Maldives, ended 1-0. It is the first victory in an international soccer contest for the Palestinians since the establishment of the Palestine Football Federation in 1928, sport officials said.
"Congratulations to our people, Palestine today is proud of such an historical achievement," said Jibril Al-Rajoub, chairman of the Palestine Football Association, who watched the match among hundreds of fans in the West Bank city of Ramallah.
In Gaza City, thousands watched the match on large screens on the sandy beach, beating drums. Fireworks lit up the sky as player Ashraf Al Fawaghra scored the winning goal for Palestine with a free kick in the second half.
"It is not the World Cup, but our happiness feels like we won the World Cup," said Adel Waleed, a 45-year-old teacher who watched the game with his four children.
The Palestinians say that Israel, which controls coming and going from Gaza and the West Bank, has been restricting the movement of Palestinian athletes and have urged FIFA sanction the Jewish state unless it loosened the restrictions.
Israel cites security concerns for restricting movement between Gaza, controlled by the Islamist group Hamas, and the West Bank, where the Palestinians have limited self-rule.
FIFA President Sepp Blatter, who visited Israel and the Palestinian Territories this week, said he did not see a reason for sanctioning Israel. Blatter said he would find a solution to Palestinian demands, without elaborating.
The FIFA Congress will convene in Sao Paolo in Brazil next month.
Some said the victory inspired a feeling of unity among Palestinians, divided by a deep political rift between Hamas and the West Bank-based Fatah of Palestinian President Mahmoud Abbas. The two sides have been negotiating formation of a unity government in the past few weeks.
"This is the first-ever championship win in Palestinian history and I hope it boosts unity and reconciliation efforts," said Abdel-Salam Haniyeh, a member of the Palestinian Higher Council for Youth and Sport.
Both President Mahmoud Abbas and the rival Hamas group issued statements praising the victory in the Madlives.
(Reporting by Nidal Almughrabi in Gaza and Ali Sawafta in Ramallah; Editing by Larry King)
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