Prime Minister Jacinda Ardern says the US President's decision to recognise Jerusalem as Israel's capital will "make things difficult".
President Donald Trump announced the US Embassy will be moved to Jerusalem from Tel Aviv, and the US will officially recognise the city as the capital of Israel.
Ms Ardern said she has "no doubt that this will make things difficult".
"We've always supported a two-state solution and our view is that Jerusalem and issues around religious sites needs to be resolved within the context of establishing that two-state solution," she said.
"I think you'll see from the commentary today, this won't take us further."
She said how Jerusalem is defined needs to be determined within the context of the longstanding issues between Palestine and Israel.
United Nations Secretary-General Antonio Guterres has condemned Mr Trump's decision and called it a "moment of great anxiety."
Mr Guterres told reporters "I have consistently spoken out against unilateral measures that would jeopardise the prospect of peace for Israelis and Palestinians."
He said there is no alternative to the two-state solution, promising to do "everything in my power to support the Israeli and Palestinian leaders to return to meaningful negotiations".
The United Nations Security Council is expected to meet on Friday to discuss the decision.
US Ambassador to the United Nations Nikki Haley praised Mr Trump's decision as "the just and right thing to do."
Israel considers Jerusalem its eternal and indivisible capital and wants all embassies based there.
Palestinians want the capital of an independent Palestinian state to be in the city's eastern sector, which Israel captured in a 1967 war and annexed in a move never recognised internationally.