Recep Tayyip Erdogan was referring to the recent Israeli invasion of Gaza which has been condemned by the international community.
The invasion resulted in the deaths of dozens of Palestinians and in the destruction of scores of Palestinian homes.
Erdogan also declined an invitation to visit Israel during Thursday’s meeting.
The premier’s comments came after Turkish Foreign Minister Abdullah Gul said he was considering upgrading Turkey’s diplomatic representation to the Palestinian territories by appointing an ambassador.
The Israeli army devastated
He also hinted he might recall the Turkish ambassador to Israel for consultations in protest at Israeli actions in the West Bank and Gaza Strip.
Israel’s Infrastructure Minister, Joseph Paritzky, said he was “astonished” when Erdogan made the comments and considered walking out of the meeting.
But Paritzky said the rebuke would not weaken the strong military and economic ties between Israel and its sole Muslim ally.
He told Israel Radio: “To consider Israel a terrorist state, not to understand the fact that we are defending ourselves against terror… this amazed me.
“I am very sad to see the charismatic, intelligent leader of a friendly country compare us to terror organisations.”
Bilateral trade between Israel and Turkey reached US$1.2 billion in 2002, and Turkey has bought US$3 billion worth of Israeli weapons since 1996.
“To consider Israel a terrorist state, not to understand the fact that we are defending ourselves against terror… this amazed me”
Turkey is also a top foreign holiday destination, visited by some 300,000 Israelis a year.
While in Ankara, Paritzky oversaw the signing of a US$800 million deal for the construction of three natural gas power stations in Israel.
Turkey also recently signed a deal to sell water to Israel.
On the political front, Turkey has repeatedly offered itself as a bridge between Israel and the Palestinians.
But the overwhelming majority of Turks also sympathise with their fellow Muslim Palestinians, and Israel’s killing of elderly Hamas leader Shaykh Ahmad Yasin in March brought angry anti-Israel demonstrators onto the streets of Ankara and Istanbul.