The Church in Wales has recalled 500 copies of its magazine featuring a cartoon caricaturing the Prophet Muhammad.
The cartoon was used with an article about shared religious ancestry
The editor has resigned after the image was published in the Church's Welsh-language magazine Y Llan.
A series of cartoons sparked violent demos after appearing in European papers earlier in the year.
The Archbishop of Wales has apologised to the Muslim Council of Wales, which accepted the "unfortunate mistake".
International protests over cartoons, first published in a Danish paper last autumn, escalated after the images were republished in Norway, France, Germany, Italy and Spain earlier this year, despite complaints by ambassadors from Islamic countries.
Archbishop of Wales Dr Barry Morgan has personally apologised
There were protests at Danish embassies in Europe and the Middle East, while those in Syria and Lebanon were attacked and at least five people died in Afghanistan.
The Church in Wales printed the cartoon to illustrate an article in the February edition of Y Llan - or Church in English - about the shared ancestry of Christianity, Islam and Judaism.
The drawing - which was from the French magazine France Soir - shows the Prophet Muhammad sitting on a heavenly cloud with Buddha, and Christian and Jewish deities.
He is being told "don't complain... we've all been caricatured here".
The Archbishop of Wales Dr Barry Morgan told the BBC: "The article was perfectly OK, but for some reason, the editor decided to print one of these cartoons which was a gross error of judgement.
"It no way reflects the policy of the church in Wales and when I saw it I was totally horrified.
"We recalled all the papers, I personally picked up some from some churches and they have all been pulped.
"I've unreservedly apologised to my Muslim colleagues and they've been very gracious and I've said to them this in no way reflects the policy or attitude in the Church in Wales."
Dr Morgan also personally contacted Saleem Kidwai, the Muslim Council of Wales' general secretary, to apologise and to assure him that no offence had been intended.
Mr Kidwai said he regarded the latest publication as simply an "unfortunate mistake" and said inter-faith relations were very good in Wales and need not be jeopardised by the incident.
In a statement, the Church said it was "thoroughly investigating" how the cartoon came to be reproduced.
The Bishops of the Church in Wales have already made it clear that "they regret the publication of the cartoons depicting the Prophet Muhammad in various European publications, and the offence that these have caused the Muslim community", the statement added.
Last month, a Cardiff University student union newspaper was withdrawn after it printed a different cartoon.
Gair Rhydd - Welsh for Free Word - recalled 8,000 copies, suspended its editor and issued a public apology.
It was thought the paper was the first UK publication to use any of the controversial cartoons.