The Palestinian president returned triumphantly to the West Bank on Sunday, receiving a boisterous welcome from thousands of cheering supporters at a rally celebrating his people's new acceptance to the United Nations.

An Israeli decision to cut off a cash transfer to the financially troubled Palestinian Authority, following an earlier decision to build thousands of new homes in Jewish settlements, failed to put a damper on the celebrations.

Palestinians celebrate the UN General Assembly's upgrading of the Palestinians' status from observer entity to non-member state in the West Bank city of Ramallah. (Ammar Awad/Reuters)

But Palestinian officials acknowledged they were undecided on what to do with their newfound status, and were waiting for upcoming Israeli elections and new ideas from President Barack Obama before deciding how to proceed.

Outside the headquarters of President Mahmoud Abbas in the West Bank city of Ramallah, some 5,000 people thronged a square, hoisted Palestinian flags and cheered their leader's return from New York. Large posters of the Palestinian leader, whose popularity had plummeted in recent months, adorned nearby buildings.

"We now have a state," Abbas said to wild applause. "The world has said loudly, 'Yes to the state of Palestine."'

The United Nations General Assembly last week overwhelmingly endorsed an independent Palestinian state in the West Bank, east Jerusalem and the Gaza Strip, territories Israel captured in the 1967 war.

The move to upgrade the Palestinians to a nonmember observer state does not change much on the ground, but it carries deep potential significance.

International condemnation

The vote amounted to an international endorsement of the Palestinian position on future border arrangements with Israel and an overwhelming condemnation of Israeli settlements in the areas claimed by the Palestinians.

Israeli Prime Minister Benjamin Netanyahu rejects a return to Israel's 1967 lines. Israel remains in control in parts of the West Bank and considers east Jerusalem, the Palestinians' hoped-for capital, an integral part of its capital.

Israel also continues to restrict access to Gaza. Israel withdrew seven years ago from the coastal strip, and it is now ruled by Hamas Islamic militants who regularly fire rockets at Israel.

Israel, backed by the U.S., campaigned strongly against the statehood measure, accusing the Palestinians of trying to bypass direct peace negotiations, which it said were the only viable path to a Palestinian state.

The Israeli lobbying efforts failed miserably. Just eight other countries voted with Israel, and even its closest allies in Europe, including Germany, Italy, France and Britain, either abstained or voted with the Palestinians.

Israel responded strongly and swiftly. The following day, it said it would start drawing up plans to build thousands of settlement homes, including the first-ever development on a crucial corridor east of Jerusalem.

Although the project is likely years away, if it happens at all, the announcement struck a defiant tone.

'Grave concern' over Israeli settlements

Building in the area, known as E1, 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. The Palestinians claim such a scenario would essentially kill any hope for the creation of a viable state.

'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'—Israeli Prime MInister Benjamin Netanyahu

UN Secretary-General Ban Ki-moon expressed "grave concern" at the Israeli announcements, saying the new building and reported planning in the E1 area "would represent any almost fatal blow to remaining chances for securing a two-state solution," UN spokesman Martin Nesirky said.

"In the interests of peace, any plans for E1 must be rescinded," he said.

"The secretary-general repeats his call on all concerned to resume negotiations and intensify efforts towards a comprehensive, just and lasting peace and urges the parties to refrain from provocative actions," Nesirky said.

The U.S., Britain, France and other European states all denounced the plan.

On Sunday, the European Union's foreign policy chief, Catherine Ashton, expressed concern that such settlement expansion "may represent a strategic step undermining the prospects of a contiguous and viable Palestine with Jerusalem as the share capital of both it and Israel. She urged Israel to show its commitment to the early renewal of peace talks but not going ahead with the settlement plan.

"The European Union has repeatedly stated that all settlement construction is illegal under international law and constitutes an obstacle to peace," Ashton said in a statement.

• Israel withholds taxes collected or Palestinian Authority

On Sunday, the Israeli government delivered another blow, saying it would withhold more than $100 million in funds it transfers to the Palestinians each month.

Instead, it said the money — taxes and customs duties that Israel collects on behalf of the Palestinians — would be used to pay off its debts to Israeli companies, including $200 million owed to the state-run Israel Electric Corp., government officials said.

'Israel rejects the UN General Assembly decision'

The monthly transfers are crucial for the cash-strapped Palestinian Authority to pay salaries to its tens of thousands of civil servants and security forces. Israel has taken similar measures in the past before eventually releasing the money.

Only nine countries voted against the Palestinian Authority's bid to have its status in the UN upgraded to state recognition. (CBC)

At the weekly meeting of his Cabinet, Netanyahu said the Palestinian statehood campaign was a "gross violation" of past agreements calling for disputes to be resolved through negotiations.

"Accordingly, the government of Israel rejects the UN General Assembly decision," he told his Cabinet on Sunday. He also pledged to continue building settlements.

"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."

Israel OKs 3,000 new homes in West Bank, East Jerusalem

Half a million settlers live in the West Bank and east Jerusalem. The ongoing growth of the settlements is at the heart of the current impasse in peace efforts.

The Palestinians view continued settlement expansion as a show of bad faith and refuse to return to negotiations unless construction is frozen.

Netanyahu has claimed a brief settlement slowdown in 2010 failed to jump-start negotiations, and he has refused calls for a new construction freeze.

Trading blame for deadlock

The new Israeli settlement construction plans remain far from certain and may have been announced by Netanyahu to impress voters ahead of the election.

New figures from Israel's Central Bureau of Statistics show 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.

Israel insists that the Palestinians are responsible for the deadlock, accusing them of refusing to recognize Israel as the Jewish homeland and the Palestinian media of glorifying violence and promoting anti-Semitic caricatures.

Netanyahu said Abbas' speech at the UN, in which he accused Israel of "ethnic cleansing" and omitted any reference of the Jewish connection to the holy land, was filled with incitement and hate.

"This is additional proof that this is not a dispute over land but a denial of the existence of the State of Israel," he said. "As long as the Palestinian Authority educates the younger generation to hate, how is it at all possible to talk about peace?"