The United States is cutting nearly $290m from a loan guarantee package to Israel in response to its settlement activity in the West Bank and Gaza.
The Israelis say a barrier is needed to stop suicide bombers
Israel is also being penalised for the building of a barrier in the West Bank to separate Israelis and Palestinians.
The move is seen as an important symbolic gesture and evidence of new US efforts to calm the conflict.
But Israel has shrugged off the rebuke, claiming no real political pressure lies behind it.
The money comes from a $9bn package of loan guarantees and does not affect Washington's direct aid for Israel.
The amount to be deducted was agreed by the two sides at a meeting in Washington on Tuesday between top officials from the White House and the office of the Israeli Prime Minister.
Broadly speaking, the US guideline is to reduce its loan guarantee by an amount equivalent to what the Israelis spend on Jewish settlement expansion in the Palestinian territories.
ISRAEL'S SETTLEMENT SPENDING
$500m - annual government budget for civilian needs (not including military protection)
Settler families receive on average $10,000 more annually from government than families living in Israel
$10bn - total spending by Israel since 1967
SOURCE: Haaretz daily newspaper, Oct 2003
Israel does not make public the figures, however an investigation by daily newspaper Haaretz in October found that government spending on civilian needs in settlements alone came to $500m a year.
The US move means Israel will not be able to raise so much money in loans from foreign banks.
It follows a warning last month by the US State Department that the Israeli Government risked being penalised if it persisted with policies inconsistent with previous understandings with Washington.
During a speech in London last week, President George W Bush delivered an unusually sharp message about the construction of settlements and "the placement of walls and fences" that
prejudice final negotiations.
But Israeli Deputy Prime Minister Ehud Olmert made light of the loan cut.
"The fact is they aren't putting any political pressure on
us to do anything on the substantive issues of the political process," he told Army Radio on Wednesday.
Earlier, the Israeli embassy even said in a statement that the amount cut had been "suggested" by Israel.
And Israel and the US have both stressed that despite the reduction, their ties remain strong.
The BBC's David Bamford in Washington says Mr Bush has domestic political reasons to be cautious in how much pressure he puts on the Israelis.
His father, George W Bush, suspended Israel's loan guarantees for similar reasons when he was president in 1991. But it created a political storm in the US that many believe contributed to his failure to win a second term as president in the following year's election.
Palestinians said the funding cut would not make change Israeli policies in occupied land.
"I'm afraid that this step as a message will not deter Israel from continuing to build the wall and the settlements," said the chief Palestinian negotiator Saeb Erekat.