The head of the Palestinian football association labelled it an "historic achievement" as the team rose two spots to 82nd in FIFA's new rankings, published today.
Israel fell 16 places to 96th 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.
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 that Thursday the rankings rise was an "historic achievement" that came despite restrictions on football in the Palestinian territories imposed by Israeli occupation.
"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.
Israel qualify for tournaments with European teams, while Palestine are in the Asian qualifying groups.
Palestine was first recognised by FIFA in 1998.
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