However, the airline insisted what they heard was not "Welcome to Palestine," an alleged gaffe that was widely reported in Israeli media, but merely a misheard Spanish word.
"My family and I were terribly offended," one passenger wrote to the company after the incident, according to Israeli media.
Yediot Aharonot newspaper even reported that the pilot, confronted by angry passengers, had locked himself in the cockpit.
Israel's embassy in Madrid complained to Iberia, the foreign ministry told AFP, adding they condemned Wednesday's incident.
The carrier initially apologised, but after an investigation later announced that -- in a typical muffled airline announcement -- it was all a question of mistranslation.
"The word 'Palestine' was not used in the announcement," the airline said in a statement.
"The captain adhered to the standard format, in which only the airports of origin and destination are named, and not countries, regions or territories," Iberia said.
"Both the airline and the crew regret the misunderstanding, which could be caused by the similar sound of the Spanish word 'destino', meaning 'destination, with 'Palestina'."
Earlier this year, Air France apologised after its in-flight map appeared to omit Israel.
The map labelled Lebanon, Jordan, the West Bank and Gaza but not Israel, because of what the airline called a technical problem.