Foreign Minister Stephen Smith today condemned the fraud as "not the act of a friend" and a clear affront to Australia that cannot be tolerated.
"This is not what we expect from a nation with whom we have had such a close, friendly and supportive relationship," he said.
In February several forged Australian passports were used in the assassination of Hamas leader Mahmoud al-Mabhouh.
Mr Smith confirmed investigations by Australian Federal Police, ASIO and ASIS showed Israel fabricated the passports of four Australians who also had Israeli citizenship.
"The high quality of these counterfeited passports points to involvement of a state intelligence service," he said.
"These investigations and advice have left the Australian Government in no doubt that Israel was responsible for the abuse and counterfeiting of these passports."
The Department of Foreign Affairs summoned the Charge D'affairs to request that it remove one of its diplomats within the week.
"The Government takes this step much more in sorrow than anger or retaliation," Mr Smith said.
"It is a decision taken in our national security interest.
"The department conveyed the Government's deep disappointment over Israel's involvement in this affair."
The diplomat who has been expelled has not been named and it is not known whether they will return or be replaced at a later stage.
Mr Smith said Australia would now work on rebuilding its relationship and reminded Israel friendship was a "two-way street".
He also said Israel should realise it is on notice that if it again fabricates Australian passports similar or stronger action would be taken.
When asked if Israel had acknowledged its part in the affair or had apologised, Mr Smith replied: "In terms of the substance of these matters Israel has not been drawn in those conversations or drawn on those matters."
A spokesman for the Israeli foreign ministry, Yigal Palmor, says it is a regrettable decision.
"It does not reflect the importance and the quality of our relationships," he said.
Deputy Opposition Leader Julie Bishop says the Government has over-reacted.
"There is no actual proof that the Israeli government was involved - there is an assumption," she said.
Nicole McCabe, Joshua Bruce, Adam Korman and Joshua Krycer have been named as the Australians whose passports were forged. All four live in Israel.
Mr Smith says replacement passports have been issued and consular assistance is still being provided to the four Australians.
An Australian Federal Police (AFP) team travelled to Israel to investigate the matter as well as the director-general of ASIO earlier this month.
Dubai authorities had said they were almost 100 per cent certain the Israeli spy agency, Mossad, was responsible for the hit.
Dubai claimed the assassins also used Irish, French and German passports to travel through the state.
Israel has maintained there is no proof it was behind the assassination.
Earlier this year, Britain expelled an Israeli diplomat after an investigation by its Serious Organised Crime Agency found that 12 forged British passports used in the assassination were copied from real documents.
It said the copies were made after the passports were handed over for inspection "to individuals linked to Israel".