Prime Minister Scott Morrison has warned coalition colleagues against further amplifying China's incendiary social media attack on Australia.
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A senior Chinese official inflamed tensions after publishing a doctored image of an Australian soldier holding a bloody knife to the throat of an Afghan child.
The provocative piece of propaganda referenced allegations of war crimes including murder and torture by Australian troops in Afghanistan.
Mr Morrison acknowledged the serious situation in bilateral relations when he joined a coalition partyroom meeting in Canberra via video on Tuesday.
He said the government made clear its response to the post.
"That doesn't need any further amplification," the prime minister told colleagues.
"Our work is focusing on establishing dialogue that allows us to steadily work through issues as governments."
Mr Morrison on Monday described the image as repugnant and demanded China apologise and take it down.
Neither was forthcoming, with the Chinese foreign ministry doubling down and suggesting Australia do some soul-searching over the actions of its special forces.
The Chinese embassy in Canberra also responded, saying the "rage and roar" of some Australian politicians was a misreading of and overreaction to the social media post.
It described an official complaint lodged by Australia's foreign affairs secretary as unwarranted and unacceptable.
"It's our advice that the Australian side face up to the crimes committed by the Australian soldiers in Afghanistan, hold those perpetrators accountable and bring justice to the victims," the embassy said.
"We also urge the Australian side face up to the crux of the current setback of bilateral relationship and take constructive practical steps to help bring it back to the right track."
Mr Morrison told the partyroom meeting Australia's objectives were to uphold national interest and values, while also striving to maintain a working relationship with China.
Labor has joined the government in condemning the "cheap and offensive" image.
"I think it's very important that we respond in a calm and measured way and make very clear what we believe is acceptable," Labor foreign affairs spokeswoman Penny Wong said.
"The offensive doctored photograph is not the behaviour of a responsible, mature, international country."
Afghanistan's ministry of foreign affairs released a statement confirming it was investigating the image.
"The Islamic Republic of Afghanistan believes that both Australia and China are key players in building and maintaining international and regional consensus on peace and development in Afghanistan," it said.
"Afghanistan hopes to maintain and strengthen cooperation with the two countries."
The bitter public spat is playing out at the same time as a worsening trade dispute between Australia and China.
China has hit a wide range of Australian exports including coal, timber, grain and seafood with bans and tariffs.
The Australian wine industry has been especially hard hit.
China is furious with Australia for demanding an investigation into the origins of coronavirus, speaking out about human rights abuses, and clamping down on foreign investment and interference.
During the debate on new powers to check foreign investment arrangements made by states and universities, Foreign Minister Marise Payne said the changes were about protecting Australia's national security and sovereignty.
She said the vast majority of deals would not be impacted, but if an arrangement was inconsistent with Australian foreign policy it should not proceed.
Australian Associated Press
