The debate follows an incident on Sunday when a group of far-right One Nation supporters stormed a Gosford church service, dressed as Muslims and spouting anti-Muslim rhetoric.

One Nation leader Pauline Hanson said the stunt was "counterproductive" to the serious argument her party was seeking in the next term of Parliament. But her party insisted freedom of speech was a key tenet of Australia's democracy, and warned of "civil unrest" if political leaders failed to heed public concern about Islam.

The NSW government is formulating a long-awaited overhaul of racial vilification laws, promising to strengthen the legislation and streamline it to make prosecutions easier. Fairfax Media understands the government will not consider including religion in the Act, which outlaws inciting violence based on race, colour, descent or ethno-religious origin.

The decision comes amid increasing anti-Muslim abuse and political rhetoric, including a sharp increase in anti-Muslim online abuse, according to the Online Hate Prevention Institute.

It also coincides with a new push for the repeal of section 18C of the national Racial Discrimination Act, which makes it unlawful to publicly "offend, insult, humiliate or intimidate another person or a group of people" on the basis of race. Opponents say the measure restricts freedom of speech.

NSW Attorney-General Gabrielle Upton would not say why religion would be omitted. However a spokeswoman pointed to the government's 2013 review of the Act, which made no recommendation to include religion.

In that review, the NSW Council for Civil Liberties was among those who opposed the inclusion of religion. The council's president Stephen Blanks told Fairfax Media that religion was "not an inherent characteristic of a person like race is ... and one should be free to criticise religion".

The government's ruling means NSW has become the only eastern state or territory not to outlaw religious-based hate speech, after the ACT passed laws this month.

Ahmed Kilani, an imam and founder of the Muslim Village website, said it was "a huge slap in the face to Australian Muslims in a time of rising Islamophobia".

"It will also play into the hands of those that are trying to radicalise our youth by confirming their recruitment call that the government applies hypocritical double-standards when it comes to Muslims," he said. "The law should either protect everyone equally or protect nobody at all."

Clarke Jones, a counter-terrorism adviser to the government and co-director of the Australian Intervention Support Hub, said religious abuse was "one of the major driving issues leading to potential acts of violent extremism".

"We have to do something about people that are ostracising Muslims,"' he said. "It is fuelling the fire."

Muslim Legal Network president Zaahir Edries said the proposed inclusion of religion in the Act was not intended to stifle free speech but, rather, the promotion of violence.

The rise of One Nation has emboldened anti-Islamic groups such as the Party for Freedom, which burst into the Gosford Anglican Church during Sunday's service.

The group has celebrated One Nation's political resurrection and its Facebook page features Senator Hanson's face as its profile picture. Australian Federation of Islamic Councils president Keysar Trad on Monday said Senator Hanson had "inspired" the stunt, but the One Nation leader insisted she was not to blame.

In a separate statement, One Nation said freedom of speech was "a valued part of Australia's democracy" and that the church protest showed "tensions are high in the community when it comes to the topic of Islam".

"If these concerns are not addressed, we believe that there may come a time where there is civil unrest on our streets," it said.

Opposition Leader Bill Shorten slammed the stunt, saying the group was "way out of line staging a protest in a Christian church".