He's considered to be a good ruler both in the Christian and Muslim world, but often for different reasons. To start with, like many celebrated medieval leaders, a lot of his reputation is due to his military successes, such as at the Battle of Hattin in 1187 where he decisively defeated a crusader force. Often great victories like that can outshine a leader's shortcomings, and in the case of Saladin that led people to ignore the financial problems his state faced throughout his life due to all the wars he was involved in (I read somewhere that he basically used the loot from one war to pay for the next, and so on). His good reputation in Europe is probably partly due to the correspondence he had with Richard the Lionheart, whom he made the peace treaty ending the Third Crusade with, and King Guy of Jerusalem, whom he captured after Hattin but then allowed to go free. Saladin and Richard even talked about having Richard's sister marry Saladin's brother as a sign of goodwill between Muslims and Christians, which never materialised but reflects the willingness that they had to co-operate with each other, something that surely reflected well on the Muslim leader in the Christian world. So, overall, his actions gave him an image as a merciful leader and respected general.

On Jerusalem, if I remember correctly, Saladin allowed Arab Christians to live and worship within the city but, as you would expect, re-converted buildings the Dome of the Rock back into a mosque. He was far from a paragon of virtue though: I think upon the capture of Jerusalem he sold about a quarter of the Latin population into slavery, whilst letting the others flee to Acre. Still, compared to the crusaders' capture of Jerusalem in 1099 (where they massacred a significant portion of the population, Muslim and Jew alike), this was a pretty measured response.

I hope this answers your question to a decent extent. I don't know much about Saladin's domestic policies, so that's probably another area to look into, as good domestic policies would have greatly boosted his reputation in the Muslim world.