El Salvador, the only country that still has its embassy in Jerusalem, is to move it to Tel Aviv.
Franciso Lainez, El Salvador's foreign minister, announced the decision on Friday that would see his country follow the example of neighbouring Costa Rica which said last week it would pull its diplomatic mission out of the disputed city.
Lainez said El Salvador hoped to help ease Middle East tensions by moving the embassy.
The decision is a blow for Israel as it regards East Jerusalem as part of its "undivided and eternal capital".
It captured the eastern part of Jerusalem in the 1967 Middle East war and annexed it in a move that has not been recognised internationally.
The 200,000 Arab residents of East Jerusalem are caught between Israel and an emerging Palestinian state which wants the eastern part of Jerusalem as its future capital.
Jonathan Peled, Israel's ambassador in El Salvador, said: "We have expressed our regret for the decision taken."
El Salvador, which set up its Jerusalem embassy in the early 1980s and whose president Tony Saca is of Palestinian Christian descent, said it hoped to stay on good terms with Israel.