The study aims to examine the feasibility of recycling autoclaved aerated concrete waste (AACW) on a vast scale to prepare sustainable mortars without large mechanical strength reduction. The recycled AACW was utilized as fine aggregate to partially replace natural river sand in mortar with various replacement levels and particle sizes. The physical properties and mechanical strength of prepared mortars were investigated experimentally. The internal curing effect of the AACW and the interfacial transition zone between recycled fine aggregate and cement paste were characterized from microstructural perspectives. Results indicate that the incorporation of AACW decreased the density and increased water absorption and voids volume of mortar. At a particle size of 0.15–0.3 mm, the higher compressive and flexural strength of mortars were observed and AACW can successfully be recycled into fine aggregate to replace up to 50% of the river sand in mortar. The internal curing effect of AACW improves the hydration of investigated mortars, and the increased crystalized calcium-silicate-hydrate is conducive to enhancing the mechanical strength of mortars. Furthermore, the backscatter scanning electron images demonstrate that the internal curing effect of AACW reduces the formation of cracks in the recycled fine aggregate/cement paste interfacial transition zone. The findings of the present work can provide a guidance for recycling AACW into fine aggregate on a vast scale to prepare sustainable mortar.