Paraguay will return its embassy back to Tel Aviv from Jerusalem, reversing a contentious decision taken months ago by the previous government.
"Paraguay wants to contribute to an intensification of regional diplomatic efforts to achieve a broad, fair and lasting peace in the Middle East," Foreign Minister Luis Alberto Castiglioni said on Wednesday.
In response, Israel announced it will close its embassy in Paraguay and recall its ambassador, the Haaretz newspaper quoted Prime Minister Benjamin Netanyahu's office as saying.
The Palestinians, meanwhile, will "immediately" open an embassy in Paraguay, Foreign Affairs Minister Riyad al-Maliki said, according to the official news agency Wafa.
Al-Maliki hailed Paraguay's change of mind as "a new Palestinian diplomatic achievement".
Paraguay's former President Horacio Cartes travelled to Jerusalem to inaugurate the embassy in May. But Cartes' successor, Mario Abdo Benitez, also a member of the conservative Colorado party, took office last month and reversed the decision.
"So much for the everlasting friendship between Paraguay and Israel, professed by Benjamin Netanyahu ... in May, when Paraguay's former president Horacio Cartes decided to move its embassy from Tel Aviv to Jerusalem," Al Jazeera's Lucia Newman said.
"At that time many people couldn't find a logical explanation [for that decision], there has been very, strong speculation that there might have been an economic incentive.
"But now there is a new president, Mario Abdo .. [and] he says he is putting things back to where they were, he says that he wants Paraguay to contribute to regional efforts to help bring about a diplomatic and lasting solution to the conflict in the Middle East."
"Paraguay is a country of principle," Abdo said on Twitter. "We will always be respectful with international law," he added.
In December, US President Donald Trump recognised Jerusalem as Israel's capital, reversing decades of American policy and upsetting the Arab world and Western allies. The US opened a new embassy in the city on May 14. Two days later, Guatemala also opened its embassy in Jerusalem.
The decision by the three countries was hailed as a political victory by Israel as it pressed other countries to recognise Jerusalem as its capital.
But the relocations drew Palestinian and international anger. Deadly protests in Gaza and the West Bank also took place.
Palestinian leaders see East Jerusalem as the capital of their future state and said Trump's move disqualified Washington as a peace mediator.
Previous US presidents, as well as nearly every other country, refrained from opening embassies in Jerusalem, saying the city's final status should first be resolved through Israeli-Palestinian negotiations.
Saeb Erekat, secretary-general of the executive committee of the Palestine Liberation Organization, had condemned the opening of the Paraguayan embassy in Jerusalem.
"We have witnessed today how the Paraguayan president is an irresponsible political leader by defying international law and the achievement of a just and lasting peace in the Middle East," he said.
Netanyahu has attempted to persuade other countries to follow the US' lead.
On Wednesday - while meeting Bulgarian Prime Minister Boyko Borissov - Netanyahu said: "I appreciate your decision to open an honorary consulate in Jerusalem, and I hope, I hope, I hope it's the first step towards establishing the Bulgarian embassy in Jerusalem."