Australia has decided to remove the term "occupied" when referring to East Jerusalem.
The issue flared in the upper house Senate this week with Attorney-General George Brandis issuing a statement to clarify Canberra's stance on the controversial question of the legality of settler homes.
"The description of areas which are the subject of negotiations in the course of the peace process by reference to historical events is unhelpful," he said in the statement .
"The description of East Jerusalem as 'occupied' East Jerusalem is a term freighted with pejorative implications which is neither appropriate nor useful.
"It should not and will not be the practice of the Australian government to describe areas of negotiation in such judgemental language."
He added that Canberra supported a peaceful solution to the dispute "which recognises the right of Israel to exist peacefully within secure borders and also recognises the aspiration to statehood of the Palestinian people".
Israel's army seized the West Bank, including Arab East Jerusalem, in the Six-Day War of 1967.
It later annexed the entire eastern sector, in a move that has never been recognised by the international community.
Mr Brandis sparked a heated debate on Wednesday evening in the Senate when he stated that no Australian government of either political persuasion "acknowledges or accepts" the use of the word "occupied".
A number of senators disagreed, pointing out that Australia had voted in support of UN resolutions in 2011 and 2012 where such language was used to describe the East Jerusalem settlements.
Independent senator Nick Xenophon suggested that dropping the term "occupied" would represent a "massive shift" in Australia's foreign policy, Australian Associated Press reported.
The leader of the Australian Greens Christine Milne Friday called it "an outrageous backdown" by the Tony Abbott-led government.
"It is inflammatory behaviour and at odds with the peace process," she said in a statement.
"The use of the term 'Occupied Palestinian Territories' is the accepted term used by the UN.
"The Israeli settlements built after 1967 are illegal. The settlements contravene the Fourth Geneva Convention."