The drill was intended to evaluate the readiness of the civil defence units, police, army and prison service to contain large-scale riots by Israel's Arab minority in response to such a deal.
The transfer scenario echoes a proposal by Avigdor Lieberman, Israel's far-right foreign minister, for what he has termed a "population exchange".
Lieberman proposes land swaps that would force many of Israel's 1.3 million Arab citizens into a future Palestinian state in return for annexation to Israel of most of the Jewish settlements in the West Bank. The scheme has been widely criticised as a violation of international law.
The training exercise has fuelled fears among Israel's Arab minority that the government might be hoping to pressure Mahmoud Abbas, the president of the Palestinian Authority, to agree to land and population swaps as part of US-sponsored peace negotiations, which have stalled.
Dov Chenin, a member of the Israeli parliament representing the joint Jewish-Arab Communist Party, called Tuesday for more details of the exercise from the government during a speech in the chamber, although officials offered no immediate response.
"A few years ago, only the extreme right-wing parties talked about transferring Arab citizens, but now we see that even the security forces are preparing concrete plans for carrying out such a scenario."
Netanyahu demanded this week that the Palestinians recognise Israel as a Jewish state before further progress was possible -- a move seen by the Arab minority as a threat to its status inside Israel. A US State Department spokesman referred to recognition as "a core demand" and said it had Washington's support.
Haneen Zoubi, an Arab member of parliament, said the exercise was designed to send "very clear messages" to the Arab minority and Abbas' negotiators.
"Netanyahu is letting us know that we are not part of his vision of Israel's future as a Jewish state and that, if we try to resist his plans, our protests will be greeted with violent repression," she said.
"He also wants the Palestinian negotiators to understand his minimum requirements for an agreement. He is not interested in justice for the Palestinians or in creating a viable state."
The exercise envisioned extensive disturbances by Israel's Arab citizens, one-fifth of the population, as security forces prepared to enforce border changes that would forcibly relocate many to a new Palestinian state, according to her report.
In the operation, code-named Warp and Weft, the security services established a large detention centre in the Galilee region between Nazareth and Tiberias to cope with an "unprecedented" number of arrests of Arab citizens.