The head of the Palestinian football association labelled it an "historic achievement" as the team rose two spots to 82nd in FIFA's latest rankings.
Israel fell 16 places to 98th after a disappointing failed World Cup qualification campaign.
Palestine have recently won a series of games as they seek to qualify for the 2019 Asian Cup, including a 10-0 victory over Bhutan.
The announcement comes as the Palestinian football association has campaigned to encourage FIFA to take action against six Israeli clubs located in settlements in the occupied West Bank.
Settlements are considered illegal under international law, and the Palestinians had asked FIFA to take action against the Israeli FA.
Last month, FIFA decided it would not intervene in the matter, with the Palestinians accusing the body of bowing to Israeli pressure.
Palestinian FA boss Jibril Rajoub told AFP Thursday the rankings rise was an "historic achievement" that came despite restrictions on football in the Palestinian territories imposed by Israeli forces.
"With this classification, we have defeated the occupation's measures and its daily harassment, from preventing the freedom of movement of athletes through to all measures that impede Palestinian sport," he said.
The Israeli Football Association said the country's sports minister had ordered the formation of a committee to examine the reasons for the lack of success.
"We wish the Palestinians all the best as always," a spokesman for the IFA said, adding they were willing to play a friendly match against them any time.
"May the best team win," he said.
Israel qualify for tournaments with European teams, while Palestine are in the Asian qualifying groups.
Palestine was first recognised by FIFA in 1998.
Eyewitness? Submit your stories now via social or:
Email: eyewitness@pulse.com.gh
