Foreign Minister Avigdor Lieberman slammed the demonstration, saying "I suggest those waving Palestinians flags march directly to Ramallah and remain there."
The demonstration took place in the Israeli village of Lavi, which was built on the ruins of the Palestinian village of Lubya. Lubya was home to 2,726 Palestinians until 1948, when Jewish forces captured the village during the Arab-Israeli conflict that led to the creation of the Jewish state.
Demonstrators waved Palestinian flags and read out the names of 530 Palestinian villages that were emptied 66 years ago, before observing a minute's silence in their memory.
"A demonstration organized by Israeli Arab associations gathered about 10,000 people and two youths were arrested for violence against the police," Israeli police spokeswoman Luba Samri said.
Groups demanding the right of return for Palestinians expelled from their homes in 1948 organised the event under the slogan: "Your 'independence' day is our 'Nakba'," Arabic for catastrophe.
MK Hanin Zoabi cynically commented on Independence Day, saying "it is certainly strange that I don't celebrate Independence Day, the historical event that saw my people expelled. I need the Nakba memorial day to battle Israeli repression."
Qassem Bakri, an Israel-Arab social activist, said "we are convinced that the Palestinian people deserve to actualize their dream of establishing an independent Palestinian state whose capital is Jerusalem.
"It is unconceivable that the Palestinian people who were expelled from their lands will not be allowed to return. This dream will come true soon, there is no choice but to establish an independent state."
"There will be no peace, no stability and no reconciliation without the refugees' right of return," Arab MK Mohammad Barakei told AFP.
More than 760,000 Palestinians - estimated today to number 4.8 million with their descendants - fled or were driven from their homes in 1948.
Palestinians mark Nakba day on May 15, but Arab Israelis hold demonstrations on Israeli Independence Day, which fell on Tuesday this year.
Around 160,000 Palestinians stayed behind and are now known as Arab Israelis. They number about 1.3 million and make up some 20 percent of Israel's population.
Most of Lubya's original inhabitants settled in the Yarmuk refugee camp in the suburbs of Damascus.
In Israeli-annexed East Jerusalem, police dispersed a demonstration by Jewish extremists, who marched through the streets of the Old City chanting anti-Arab slogans, the police spokeswoman said.
They also shouted "Temple Mount is in our hands" - a reference to IDF Col. Motta Gur's famous line, whose led the forces who captured the mount during the Six Day War.
Police arrested two of the demonstrators who tried to force their way past a checkpoint, she added.
Attila Somfalvi contirbuted to this report