The man, named by the court as Anan Kamal Afif Yaeesh, 36, was one of three Palestinians arrested in central Italy on suspicion they were planning attacks in an unspecified country.
Israel applied for the extradition of Yaeesh, but his lawyer opposed the request, presenting reports by Amnesty International and Human Rights Watch on prison conditions for Palestinians held in Israeli prisons.
In a written ruling, a panel of three judges in the central city of L'Aquila sided with the defence, saying Yaeesh would face "acts constituting a violation of human rights" if the extradition request was granted.
However, they ruled that he should be kept in prison in Italy because he is being investigated by the public prosecutor's office for the same charges for which Israel had requested his extradition.
The substance of the allegation against him was not discussed in the hearing. Israel has repeatedly said detainees and prisoners are treated in accordance with international law.
Israel, which is at war with the Palestinian militant group Hamas in the Gaza Strip, has accused Yaeesh of financing an armed group from the Tulkarem refugee camp in the West Bank, called the Tulkarem Brigade.
Italy said on Monday the three arrested Palestinians had set up a cell linked to the Al-Aqsa Martyrs Brigades, an armed group linked to Palestinian President Mahmoud Abbas' Fatah movement. The group is considered a terrorist organisation by Israel, the European Union and the United States.
The other two did not appear in court because Israel has not requested their extradition.
(Reporting by Emilio Parodi, Editing by Crispian Balmer and Alison Williams)
