The Prime Minister said it is not acceptable for any outside powers to tell the people of another country what to do.
He was responding to the announcement of Australian Prime Minister Scott Morrison on Saturday (Dec 15) that Australia formally recognises West Jerusalem as Israel's capital.
Morrison had said that Australia will be moving its Israeli embassy from Tel Aviv to Jerusalem.
Dr Mahathir said the Australian government has no right to interfere in the situation between Israel and Palestine regarding Jerusalem.
"We noticed that the words that he (Morrison) used are very carefully constructed, I suppose in order to reduce the possibility of stirring up more anger towards Australia.
"Nevertheless, in the eyes of many Arab countries and Palestine, this is not something that they can accept.
"Jerusalem should remain as it is now and not the capital of Israel.
"Of course, according to the Australians, eventually West Jerusalem should be the capital of Israel and East Jerusalem should be the capital of Palestine.
"But for outside countries to impose conditions and to tell people what to do in their own countries, that is not acceptable.
"Jerusalem has always been under Palestine, so why are they taking the initative to divide Jerusalem, which does not belong to them, but to divide between the Arabs and the Jews? This is not right," said Dr Mahathir.
He was speaking to the media in Thailand after receiving an honorary doctorate degree for leadership in social, business and political issues from Rangsit University here on Sunday (Dec 16).
This is not the first time Dr Mahathir and Australia have been caught up in a war of words over the move of Australia's embassy move.
Dr Mahathir has defended his stance by stating that it is his right to "free speech".