The Palestinian Foreign Ministry hailed the move as a "Palestinian diplomatic achievement".
Cartes even joined Netanyahu in the new embassy's opening ceremony in Jerusalem in May. He was replaced by Mario Abdo, also a member of the conservative Colorado party, last month.
Shortly after, Netanyahu's office responded by saying it will close its Paraguay embassy and recall its ambassador for consultations.
"Israel views with utmost gravity the extraordinary decision by Paraguay, which will cloud bilateral relations", the Israeli Prime Minister's Office said in a statement on Wednesday.
Paraguay said it made the move because it wanted to intensify "regional diplomatic efforts to achieve a broad, fair and lasting peace in the Middle East".
According to reports, the U-turn came after a re-examination by Paraguayan Foreign Minister Luis Alberto Castiglioni who deemed the original decision of former President Horacio Cartes as "unjustified".
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Palestinian foreign minister Riyad al-Maliki claimed on Wednesday that he pushed President Benitez to reverse the move to Jerusalem. "Paraguay has always been a leader among Latin American nations in advancing cooperative relations with Israel".
Palestinian Authority President Mahmoud Abbas celebrated as "courageous" the reversal, which will be a setback to the momentum Israel had hoped to build after the United States moved its embassy to Jerusalem al-Quds in May as part of President Donald Trump's so-called Middle East peace efforts.
Guatemala became the first nation to follow suit when it officially declared on December 24 that it would be moving its embassy to Jerusalem. "This is also time for [President Donald] Trump's administration to realize that no peace-loving country will follow their decision to recognize Jerusalem as Israel's capital", he added.
"There are over 85 countries who maintain their embassies in Tel Aviv and we are friends and historic allies of Israel".
Hours after the move, Palestinian Foreign Ministry announced that Palestine has chose to establish an embassy in Paraguay's capital, Asuncion, in appreciation and released a statement. "Paraguay considers that it has to be addressed through negotiations by the concerned parties, within the framework of the relevant global organizations' decisions", the statement continued.
Castiglioni said Paraguay had always been "predictable in its worldwide relations" but that Cartes's move was "a distortion of this tradition and culture of respect for global law" and United Nations decrees.