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Palestinians in Ramallah hold placards depicting President Mahmoud Abbas marking the UN General Assembly's upgrading of the Palestinians' status from observer entity to non-member state. (Ammar Awad/Reuters)

Israel on Sunday roundly rejected the United Nations' vote in favour of the Palestinian Authority's bid to have its status in the UN upgraded to a non-member observer state and announced it would withhold more than $100 million collected for the Palestinian government to pay debts to Israeli companies.

The UN General Assembly voted overwhelmingly on Thursday to support the Palestinians' initiative for such recognition.

The following day, Israel announced it would start drawing up plans to build thousands of settlement homes, including the first-ever residential developments on a sensitive piece of land near Jerusalem. Actual construction would be years away.

Prime Minister Benjamin Netanyahu declared the statehood campaign, led by Palestinian President Mahmoud Abbas, as "a gross violation of the agreements signed with the state of Israel."

"Accordingly, the government of Israel rejects the UN General Assembly decision," he said. Israel, backed by the U.S., campaigned against the statehood measure, arguing that only negotiations can deliver a Palestinian state.

Abbas returned home Sunday to a hero's welcome in the West Bank city of Ramallah. Some 5,000 people thronged a square outside his headquarters, hoisting Palestinian flags and cheering. Large posters of the Palestinian leader, whose popularity had plummeted in recent months, adorned nearby buildings.

Abbas warned of "creative punishments" by Israel. Referring to the latest settlement construction plans, he said, "We have to realize that your victory has provoked the powers of war, occupation and settlements because their isolation is deepened."

Money collected from labourers, businesses

On Sunday, Finance Minister Yuval Steinitz said the government would withhold taxes and customs collected from Palestinian labourers and businesses on behalf of Abbas' Palestinian Authority, which led the statehood campaign.

The money will be used to help pay off the authority's debts to Israel, including $200 million owed to the state-run Israel Electric Corp., government officials said. This month, more than $100 million was to have been transferred. Steinitz said Israel would decide later whether to withhold future transfers as well.

The General Assembly decision late Thursday to accept "Palestine" as a non-member observer state in the West Bank, east Jerusalem and Gaza did not grant actual independence to the 4.3 million Palestinians living in those areas.

'We will continue to build in Jerusalem and in all areas that appear on Israel's map of strategic interests.'—Israeli PM Benjamin Netanyahu

Israel remains an occupying force in the first two areas and continues to severely restrict access to Gaza. The coastal strip, located on the opposite side of Israel from the West Bank, is now controlled by the militant Hamas. Israel withdrew in 2005.

"Today we are building and we will continue to build in Jerusalem and in all areas that appear on Israel's map of strategic interests," Netanyahu told his cabinet.

Half a million settlers live in the West Bank and east Jerusalem.

Israel announced Friday that it would press ahead plans to build 3,000 housing units in the West Bank and east Jerusalem, the core of the Palestinians' hoped-for state.

'Setback to negotiated peace'

More worrisome for the Palestinians, it vowed to dust off a master plan to build 3,600 apartments and 10 hotels on the section of territory east of Jerusalem known as E1. The Palestinians have warned that such construction would kill any hope for the creation of a viable Palestinian state.

Building there would sever the link between the West Bank and east Jerusalem, the sector of the holy city the Palestinians claim for a future capital, and cut off the northern part of the West Bank form its southern flank.

U.S. Secretary of State Hillary Rodham Clinton said these plans "set back the cause of a negotiated peace."

Britain and France urged Israel to rescind the decision, and other European states denounced it.

The decision may be connected more to Israeli politics than an actual policy change. Netanyahu is up for re-election in Jan. 22 parliamentary elections and is eager to put on a strong face for the electorate. Actual construction could be years away, if it takes place at all.

"There is no decision to build," Housing Minister Ariel Attias told Army Radio on Sunday. "There is a decision to plan. You can't build an apartment without planning."

New figures from Israel's Central Bureau of Statistics showed that Netanyahu has actually slowed settlement construction over the past year.

The latest figures found that Israel began construction on 653 new settlement homes in the first nine months of 2012, down 26 per cent from 886 housing starts during the same period a year earlier.