"This is about breaking the people smugglers' business model," Immigration Minister Chris Bowen said.
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"This now means that people smugglers will need to find 800 volunteers to pay their money, risk their lives, come to Australia with the prospect of a plane ticket to Malaysia.
"People smugglers will now have a much tougher job in selling their product.
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Bowen said Malaysian officials had indicated that people would be processed swiftly and treated with dignity and respect while their claims for refugee status were assessed.
But refugee campaigners in both countries attacked the proposal, saying it would not stop thousands of asylum seekers from risking their lives on perilous boat journeys to Australia each year.
"No-one, when they set out from Afghanistan or