Leaders from within the Muslim world and from the wider international community were swift to criticise the move, and warned of the potential for violence and bloodshed as a result.
Mr Trump also approved moving the US embassy from Tel Aviv to Jerusalem, making America the first country in the world to officially recognise Jerusalem as Israel’s capital.
The status of Jerusalem lies at the heart of the long-running Israeli-Palestinian conflict, as the Palestinians claim East Jerusalem as the capital of their future state.
White House officials have said Mr Trump’s decision is a “recognition of current and historic reality” but is not a political statement, and will not change the physical and political borders of Jerusalem.
President Mahmoud Abbas said the decision was tantamount to the United States “abdicating its role as a peace mediator” after a decade of sponsoring the Israeli-Palestinian peace process.
“These deplorable and unacceptable measures deliberately undermine all peace efforts,” he said in a speech after Mr Trump’s announcement.
He insisted that Jerusalem was the “eternal capital of the state of Palestine”.
Palestinian Islamist group Hamas chief Ismail Haniyeh said: “Our Palestinian people everywhere will not allow this conspiracy to pass, and their options are open in defending their land and their sacred places.”
Israel’s Prime Minister Benjamin Netanyahu said President Trump’s announcement was a “historic landmark.”
He called the US president’s decision “courageous and just.”
The Israeli prime minister said the speech was “an important step towards peace, for there is no peace that doesn’t include Jerusalem as the capital of the State of Israel”.
He said that the city had “been the capital of Israel for nearly 70 years”.
Education Minister Naftali Bennett also hailed the decision, saying “the United States is adding another brick to the walls of Jerusalem, to the foundation of the Jewish nation”, and urged other nations to follow Mr Trump’s lead.
The Turkish Foreign Minister Mevlut Cavusoglu said the decision was “irresponsible.”
He wrote on Twitter that “the decision is against international law and relevant UN resolutions”.