The doctored image, posted by an official Chinese Government account, shows an Australian soldier holding a bloodied knife to a child's throat.
Australian Prime Minister Scott Morrison has demanded an official apology from China for the posting of an "offensive" and "outrageous" fake image of an Australian soldier holding a bloodied knife to the throat of an Afghan child.
Morrison called an unscheduled press conference on Monday afternoon to respond to the image, which was posted on Monday on the official Twitter account of China's Foreign Ministry spokesman, Lijian Zhao.
"Shocked by murder of Afghan civilians & prisoners by Australian soldiers," the caption on the post reads. "We strongly condemn such acts, & call for holding them accountable."
The remarks are a reference to the release of a damning defence report that found "credible evidence" of the alleged unlawful killing of 39 people by 25 Australian special forces troops.
"It is deeply offensive to every Australian, every Australian who has served in that uniform, every Australian who serves in that uniform today," he said.
"Everyone who has pulled on a uniform and served with Australians overseas from whatever nation, that they have done that. It is utterly outrageous and it cannot be justified on any basis whatsoever."
The Prime Minister said the fact that it was posted on an official Chinese government account was "shameful".
"The Chinese government should be totally ashamed of this post," he said.
"It diminishes them in the world's eyes. I want to make a couple of points about this. Australia is seeking an apology from the Ministry of foreign affairs, from the Chinese government, for this outrageous post. We are also seeking its removal immediately and have also contacted Twitter to take it down immediately.
"It is a false image and a terrible slur on our great defence forces and the men and women who have served in that uniform for over 100 years."
In the first public response to Morrison's comments, the editor of Chinese state media outlet The Global Times, Hu XInjin, described the PM's response as "ridiculous".
"It is a popular cartoon that condemns the Australian Special Force's brutal murder of 39 Afghan civilians," Hu wrote on Twitter.
"On what ground does Morrison feel angry over the use of this cartoon by the spokesperson of Chinese FM? It's ridiculous and shameless that he demanded China to apologise."
The row comes as debate rages in Australia over the Defence Force chief's plan to revoke military honours for 3000 special forces troops.
General Angus Campbell had argued there is "a collective responsibility" for the alleged crimes.
"I have accepted the Inspector-General's recommendation and will write to the Governor-General requesting he revoke the Meritorious Unit Citation for Special Operations Task Groups who served in Afghanistan between 2007 and 2013," the general said.
"While necessary, I appreciate that these latter decisions will be a bitter blow for many."
However, a public backlash is growing, with a petition from a leading veterans' support group opposing the revoking of citations now gathering more than 50,000 signatures.