President Donald Trump has announced that the US now recognises Jerusalem as Israel’s capital, overturning decades of official US policy.
Mr Trump described the move as “a long overdue step” to advance the Middle East peace process.
Palestinian President Mahmoud Abbas responded to the decision by saying the US could no longer be a peace broker.
The fate of the ancient city is one of the thorniest issues between Israel and the Palestinians.
Mr Trump said the US would support a two-state solution, if approved by both sides.
But Mr Abbas said that his “deplorable and unacceptable measures deliberately undermine all peace efforts”.
The Palestinian leader earlier warned of “dangerous consequences” through a spokesman, a sentiment echoed by other Arab leaders, who said there could be unrest.
Demonstrations have already taken place outside the US consulate in Istanbul, Turkey, and a large labour union in Tunisia has called for mass protests.
Speaking at the White House, Mr Trump said he had “judged this course of action to be in the best interests of the United States of America, and the pursuit of peace between Israel and the Palestinians”.
The president said he was directing the US state department to begin preparations to move the US embassy from Tel Aviv to Jerusalem.
In response, Israeli Prime Minister Benjamin Netanyahu said it was a historic day, and Israel was profoundly grateful to President Trump.
Jerusalem contains sites sacred to the three major monotheistic faiths – Judaism, Islam and Christianity.
East Jerusalem, which includes the Old City, was annexed by Israel after the Six Day War of 1967, but is not internationally recognised as part of Israel.
The US decision comes despite vocal opposition in the Muslim world, even among US allies.
On Tuesday Saudi Arabia’s King Salman said that the relocation of the embassy or recognition of Jerusalem as Israel’s capital “would constitute a flagrant provocation of Muslims, all over the world”.
But moving the embassy fulfils a campaign promise and appeals to Mr Trump’s right-wing base.
“Today, I am delivering,” the US leader said, referencing the campaign pledge.
Recognising Jerusalem as Israel’s capital was “nothing more or less than a recognition of reality”, he added.
“It is also the right thing to do.”
The decision to recognise Jerusalem as Israel’s capital is a reversal of decades of US foreign policy, and differs sharply from the rest of the international community’s view on Jerusalem’s status.
The Palestinians claim East Jerusalem as the capital of a future state, and according to the 1993 Israel-Palestinian peace accords, its final status is meant to be discussed in the latter stages of peace talks.