Holy See officials agreed to a treaty today which makes clear the Church now considers Palestine to be a country in its own right.
The move had been expected since a decision by the United Nations General Assembly in 2012 to recognise a Palestinian state was welcomed by the Vatican.
Vatican spokesman, Revd Federico Lombardi, said: "Yes, it's a recognition that the state exists".
A spokesperson for the Israeli foreign ministry said the country was "disappointed" by the Vatican's change in policy.
The Associated Press reports the ministry as having said: "This move does not promote the peace process and distances the Palestinian leadership from returning to direct and bilateral negotiations.
"Israel will study the agreement and will consider its steps accordingly."
It comes just days before Palestinian President Mahmoud Abbas visits Pope Francis at the Vatican and two Arabic nuns are canonised.
Presenter of Premier's Middle East North Africa Analysis programme, Dr Harry Hagopian, told Premier it was a big announcement.
He said: "It means there will be disappointment and probably regret expressed by Israel but the Vatican is not only a political entity but it is also a moral authority which represents many Christians and the 1.2 billion Catholics worldwide.
"This has a very strong influence on that."
Listen to Dr Harry Hagopian speaking to Premier's Marcus Jones.