Indonesia has recalled its ambassador to Australia after Canberra granted temporary visas to 42 people from the Indonesian province of Papua.
Jakarta had strongly criticised the decision by Australia to grant the visas, saying it "regretted" the move.
In a statement, it said the decision was counter to the spirit of co-operation between the two countries.
Australia has sought to defuse the row, saying it did not indicate support for Papuan separatist aspirations.
A low-level separatist insurgency has been going on for decades in Papua, where the Indonesian authorities are frequently accused of human rights abuses. The group of Papuan refugees reportedly includes leading pro-independence activists.
Papua was granted self-rule by its Dutch colonists in 1961, but was then annexed by Indonesia, which did not honour that agreement.
'Nothing to fear'
The 42 Papuans arrived in Australia by boat in January, saying they were fleeing abuses by Indonesia's military.
A decision is still to be made on a 43rd asylum seeker.
The 42 have been granted temporary protection visas - three-year renewable visas which allow immigrants to work and mean they are not detained, but limit their right to benefits and mean they cannot bring family to Australia.
Immigration Minister Amanda Vanstone said the Papuans would now be transferred from a holding centre on Christmas Island to Melbourne in southern Australia.
Indonesian Foreign Minister Hassan Wirajuda said Jakarta had formally protested and the ambassador was being recalled for consultations.
Jakarta said the refugees had nothing to fear and had warned that granting asylum could strain its relations with Australia.
Indonesia's foreign ministry released a statement criticising the move.
"The government of Indonesia is surprised, disappointed and very much regrets this decision," it said.
"The decision is counter-productive and does not take into account the sensitivities of the Indonesian people regarding this issue.
"It is against the spirit of bilateral co-operation, especially in the field of stopping illegal immigration."
Australian Foreign Minister Alexander Downer attempted to assuage Indonesia's anger, saying the move did not imply any support for separatist aspirations in Papua.