Palestinians say the work, at Ras al-Amud, in East Jerusalem, is the first violation of the Wye agreement signed in Washington last month.

Bulldozers moved onto the site almost immediately after Israeli Prime Minister Binyamin Netanyahu gave permission for the work to go ahead.

Jeremy Bowen: "Israeli peace activists chained themselves to bulldozers"

Demonstrators from the Peace Now group chained themselves to the bulldozers in a bid to stop contractors working for the hard-line Jewish settler group, Ateret Cohanim.

Police guarding the builders are reported to have arrested three of the activists.

Millionaire backing

About 11,000 Arabs live in Ras al-Amud but the construction site is owned by Irving Moskovitz, an American Jewish millionaire who finances much of the hardline settler activity in Jerusalem.

BBC MIddle East Correspondent Jeremy Bowen: "Appeasing angry right-wingers"

Israel had prevented work at the site for 14 months because of the potential political ramifications from Palestinians.

Middle East Correspondent, Jeremy Bowen, says the signs are that Mr Netanyahu gave the go-ahead to appease Israeli right-wingers, who were infuriated by the Wye agreement.

Opponents of the scheme have accused the Israeli Government of breaking faith with the Wye peace accord signed in Washington last month.

Faisal Husseini, a senior Palestinian official in Jerusalem, said it was the first violation of the peace deal.