"I share the view that this is a bad decision at the wrong time, and it's not a helpful contribution to the peace process," Foreign Minister Stephen Smith told Sky News.
Australia says new Israel settlement 'not helpful'
Israel's interior ministry on Tuesday said it had approved the construction of 1,600 new housing units in Ramat Shlomo, a Jewish settlement in the mainly Arab eastern sector of Jerusalem.
The controversial move has infuriated Palestinians, who consider settlements to be a major hurdle to a peace accord, and who want occupied east Jerusalem as the capital of a future state.
"Israel has the right to exist as a state in a context of peace and security, and the Palestinian people have their own state as well, also existing in a context of peace and security," Smith said.
"But the starting point for that has to be an effective peace process, and this has not been a helpful contribution to try to get the peace process back on the road."
Israel's plans have been condemned by a number of Western countries, including Britain and key ally the United States.
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