Israel announced Monday it is building nearly 700 new apartments for its people in east Jerusalem, where Palestinians hope to set up the capital of a future state.
The U.S., Palestinians and the European Union condemned the plan, which is a fresh setback to American efforts to restart Mideast peace talks.
The Palestinians have said they will not resume talks without an Israeli settlement freeze and criticized what they said was another show of bad faith by Israel.
"With each individual action it undertakes on the ground, Israel is saying no to meaningful negotiations," said Palestinian negotiator Saeb Erekat.
But Israel's housing ministry says the new buildings will make apartments cheaper and more affordable for young families. Plans for development have included Arab families, the government has stressed. Last week, Israel authorized the building of 500 new homes in Silwan, one of Jerusalem's Arab neighbourhoods.
U.S. President Barack Obama's Mideast envoy, George Mitchell, who is trying to find a formula for reviving negotiations, is due in Israel and the West Bank in the second week of January.
White House press secretary Robert Gibbs said the U.S. "opposes new Israeli construction in east Jerusalem" and believes neither side should take steps that pre-empt the outcome of talks. The White House urged both sides to restart negotiations without preconditions.
Sweden, which holds the rotating European Union presidency, said Israel's latest plans "prevent the creation of an atmosphere conducive to resuming negotiations on a two-state solution."
Israel insists the Jewish neighbourhoods in east Jerusalem are not settlements but part of its own capital, a view disputed by the international community.
A partition of Jerusalem — with Jewish neighbourhoods going to Israel and Arab neighbourhoods to a future Palestine — would likely be part of any peace deal. Palestinians say that with each expansion of Jewish areas, the Arab portion of the city is shrinking and partition becomes more difficult.