The meeting followed fury after Attorney-General George Brandis said the term would not be used as it carried pejorative implications and was neither appropriate nor useful.
Eighteen diplomats from countries including Egypt, Saudi Arabia and Indonesia protested and warned of possible trade sanctions.
Australia’s export trade with the Middle East accounts for billions of dollars annually, particularly in wheat and meat.
Foreign Minister Julie Bishop said there had been a “constructive” discussion and released a letter to the diplomats re-affirming there was no change in the government’s position on the legal status of the Palestinian Territories.
“Our position is consistent with relevant UN resolutions adopted over many years, including UN Security Council Resolutions 242 and 338,” it read.
“Senator Brandis’ statement was about nomenclature, and was not a comment on the legal status of the Palestinian Territories.”
While avoiding the term “occupied” altogether, it added that Australia continued to be a stong supporter of a two-state solution “with Israel and a Palestinian state existing side by side in peace and security”.
The diplomats were furious with the comments on East Jerusalem, which was annexed by Israel in a move never recognised by the international community, and concerned that it was a “substantial policy shift”.
The Palestinians claim Arab East Jerusalem as the capital of their own state.
The international community views all Israeli construction on land seized in 1967, including the West Bank, as illegal and a major obstacle to a negotiated peace agreement.
The head of the Palestinian delegation to Canberra Izzat Abdulhadi said he was satisfied with the way the meeting went.
“The foreign minister was very clear about it today, that, yes, East Jerusalem is occupied. She repeated it several times,” he told Sky News.
Abdulhadi added that it appeared Brandis, who said Australia would no longer call East Jerusalem occupied but disputed, had overstepped the mark.
“The other important development was that she said that from now on … the policy of Australia is declared by either herself or the prime minister only.”