Trump administration officials earlier described the risky move as a "recognition of reality" that the city has been used as a base for many Israeli government offices.
"My announcement today marks the beginning of a new approach to the conflict between Isreal and Palestinians," he said.
"It is time to officially recognise Jerusalem as the capital of Israel," Trump added, saying that he was fulfilling a promise that previous presidents have not honoured.
He justified his decision, saying: "Today Jerusalem is the seat of the modern Israeli government, the home of the Knesset and the Israeli Supreme Court. It is the headquarters of many government ministries."
In terms of a solution to the conflict, Trump said: "We want a great deal for the Israelis and a great deal for the Palestinians."
He added that the US was still committed to "helping facilitate a peace agreement that is acceptable to both sides" and that the US will "support a two-state solution."
"Work will soon begin on relocating the US embassy from Tel Aviv to Jerusalem," the US leader declared, ending his speech by calling for "calm and moderation".
Jordan and Palestinians called for an emergency meeting of the Arab League on Wednesday prior to Trump's announcement. Members are set to meet in Cairo on Saturday, a diplomatic source said.
The recognition will "throw the region and the world into a fire and it's not known when it will end," Deputy Prime Minister and government spokesman Bekir Bozdag wrote on Twitter, saying the move was a "great disaster" that would lead the way to "turmoil, chaos and clashes."
On the the eve of his contentious decision on Jerusalem's status, the president held calls with US allies in the Middle East to discuss the issue.
The White House said Trump talked with Saudi Arabia's King Salman and Egyptian President Abdel Fattah al-Sisi late on Tuesday, both of whom have warned Trump against moving the US embassy in Israel to Jerusalem.
Sisi urged Trump "not to complicate the situation in the region by taking measures that jeopardise the chances of peace in the Middle East," the Egyptian leader's spokesman Bassem Radi said in a statement.
Sisi also confirmed "Egypt's consistent position on maintaining the legal status of Jerusalem within the framework of international standards and relevant United Nations resolutions," he said.
Saudi Arabia's King Salman warned President Donald Trump that moving the US embassy for Israel to Jerusalem was a "dangerous step" that could rile Muslims worldwide.
"Moving the US embassy is a dangerous step that provokes the feelings of Muslims around the world," state-run Al-Ekhbariya TV quoted King Salman as telling Trump in the phone call.
In an open letter to the American president on Tuesday, Morocco's King Mohammed VI also expressed his "deep personal concern" and "the great concern felt by Arab and Muslim states and peoples" over moves to recognise the city as Israel's capital and transfer the US embassy there.
The monarch was writing as head of the 57-member Organisation of Islamic Cooperation's Al-Quds Committee, which lobbies on issues related to the city, holy to three of the world's major religions.
Earlier on Tuesday Trump informed Palestinian President Mahmoud Abbas by phone of his intention to move the embassy from Tel Aviv to Jerusalem.
Abbas "warned of the dangerous consequences such a decision would have to the peace process and to the peace, security and stability of the region and of the world," a PA spokesperson said.
The move has been widely condemned in the Arab world and internationally.
A Jordanian palace statement quoted King Abdullah as telling the US president that such a decision would have "dangerous repercussions on the stability and security in the region" and would obstruct US efforts to resume Arab-Israeli peace talks.
Israel regards Jerusalem as its capital, a position nearly the entire world rejects saying its status should be determined in peace talks with the Palestinians.
East Jerusalem, which includes the Old City, is considered occupied Palestinian territory under international law.