Attending a summit of Muslim nations in Malaysia, Iran's president said: "The real cure for the conflict is the elimination of the Zionist regime, but there should be an immediate ceasefire first."
He also urged that "any aggressor should go back to the Lebanese international border".
With regard to the idea of deploying an international peacekeeping force in southern Lebanon, he said: "The peace and security of Lebanon should be settled by the Lebanese people and government. The presence of foreign troops is unacceptable, unless they are under UN command.
"The circumstances should be prepared for the return of the refugees and displaced people, and prisoners should be exchanged."
Ahmadinejad, whose country is at odds with the West over its nuclear programme, took a swipe at Britain and its arch-foe the United States.
"The losses inflicted on Lebanon should be paid by the US and Britain which are supporters of the Zionist regime.
"We also propose that the Islamic nations immediately cut all their overt and covert political and economic relations with the Zionist regime."
Tony Blair, the UK prime minister, criticised the president's comments as "deeply unhelpful" and "quite shocking".
He said Ahmadinejad's call for the elimination of Israel showed how important it was "that we have a strong alliance of moderation to take on those people with such extreme views".
Blair said he hoped for agreement within the next few days on a UN resolution aimed at bringing about an immediate ceasefire in Lebanon.
He said: "I'm now hopeful we will have such a resolution down very shortly and agreed within the next few days.
"The purpose of that will be to bring about an immediate ceasefire and then put in place the conditions for the international force to come in in support of the Lebanese government."
Calling it a "very critical time", Blair said the UN Security Council resolution was coming together and remaining differences were very slight.
He called for a "revival and re-energising" of the Middle East peace process once the Lebanon conflict had calmed down.