- In a televised address, Prime Minister Scott Morrison said Beijing should be "utterly ashamed" for sharing the "repugnant" image.
It comes amid escalating political tensions between the two countries.
The image referred to alleged war crimes by some Australian soldiers.
Warning: This story contains an image some people might find distressing.
Earlier this month, a report found that 25 Australian soldiers were allegedly involved in the murders of 39 Afghan civilians and prisoners between 2009 and 2013.
The findings from the Australian Defence Force (ADF) inquiry sparked widespread condemnation, and are now being investigated by police.
On Monday, China's Foreign Ministry spokesman Lijian Zhao posted a doctored image which portrayed an Australian soldier with a bloody knife next to a child. The child is seen holding a lamb.
The Australian Broadcasting Corporation reported the image appeared to be a reference to unsubstantiated rumours that elite Australian soldiers used knives to murder two Afghan teenagers. However, the inquiry found no evidence to support the rumours.
The tweet said: "Shocked by murder of Afghan civilians & prisoners by Australian soldiers. We strongly condemn such acts, and call for holding them accountable."
Mr Morrison described the post as "truly repugnant, deeply offensive, utterly outrageous".
"The Chinese government should be totally ashamed of this post," he said.
Australia has also requested Twitter remove the post from its platform, describing it as "disinformation".
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from Via PakapNews