It is narrated from Sayyiduna Abu Musa (may Allah be pleased with him), he said: The Jews would sneeze in the presence of the Prophet (peace and blessings of Allah be upon him), hoping that the Prophet (peace and blessings of Allah be upon him) would say to them «يرحمكم الله», but the Prophet (peace and blessings of Allah be upon him) would say: "May Allah guide you and set your affairs right."
Hadith Referenceالادب المفرد / كتاب أهل الكتاب / 1114
Hadith Gradingالألبانی:صحيح
Hadith Takhrij«صحيح : أخرجه أبوداؤد ، كتاب الأدب : 5038 و الترمذي : 2739 و النسائي فى الكبرىٰ : 9990»
Explanation & Benefits
Shaykh Maulana Usman Muneeb
Benefits and Issues: From these narrations, it is understood that if a disbeliever (kafir) offers greetings (salam) or supplicates (makes a dua) in clear words, then it is permissible to respond to them. However, in general circumstances, it is better to suffice with saying "Wa 'alaykum" (and upon you). Similarly, it is not correct to refer to a disbeliever as "marhoom" (the one upon whom mercy has been bestowed).
Source: Fadlullah al-Ahad: Urdu Commentary on al-Adab al-Mufrad, Page: 1114