Prakash could now be freed from custody if the court determines he isn't under investigation for other crimes.
Islamic State terrorist Neil Prakash is being held in a jail in Gaziantep after being caught trying to cross the border from Syria using false documents in 2016.
Australia had been pressing Turkey to extradite Prakash since he was first detained there almost two years ago.
Senior Australian counter-terrorism officials stated he played a pivotal role in encouraging several terror plots in Australia as well as lone-wolf attack plans against the United States which landed him on a USA "kill list".
Prime Minister Turnbull stated the Australian government was determined to keep Prakesh "behind bars" whether it be in Turkey or Australia.
Ms Bishop said Australia was "disappointed" by the decision of the Kilis Criminal Court.
"Democracy is not legitimate".
Appearing in a propaganda video for Islamic State in April 2015, the former mechanic and rapper known by his nom de guerre Abu Khalid al-Cambodi, in reference to his Cambodian heritage, said that he travelled to Syria in 2013 after converting to Islam.
When asked for his response by the court, Prakash launched into an attack on the judge in a mix of English, Arabic and Turkish.
Foreign Affairs Minister Julie Bishop also expressed disappointment at the Turkish court's decision.
Australian authorities have said that Melbourne-born Prakash is linked to failed terror plots in Australia and calls for lone-wolf attacks against the US.
"Allah is the legislator, not him", he said.
A Turkish court has rejected a request to extradite Australia's most wanted terrorist.
The Melbourne native has arrest warrants out in his home country for "membership of a terrorist organization", "advocating terrorism", "providing support to a terrorist organization" and "incursions into foreign countries with the intention of engaging in hostile activities".
A Melbourne court sentenced Besim in September 2016 to 10 years in prison for his attempt to commit an act of terrorism on Australian soil.