Israel's attorney general has told the government to call an immediate halt to confiscating Palestinian property in East Jerusalem under a 1950 land law.
Hundreds of hectares of land have already been expropriated
Meni Mazuz said he was never consulted about the policy, which was secretly approved by the cabinet last summer.
He wrote to the finance minister saying the law could not be used for people absent from their property because of Israeli security measures.
The legislation entitles Israel to take Arab-owned land without compensation.
Palestinians say the cabinet decision was meant to allow the takeover of thousands of hectares of Palestinian-owned land around Jerusalem and cement Israel's control over the occupied eastern half of the city.
Hundreds of hectares have been seized in recent months, say lawyers for Palestinian landowners.
The United States has expressed concern about Israel's decision to apply the 1950 Absentee Property Law after it was brought to light last month.
A meeting between top Israeli envoy Dov Weisglass and US Secretary of State Condoleezza Rice is thought to have discussed the issue on Monday.
Mr Mazuz ruled that reviving the long-dormant law was illegal, justice ministry spokesman Jacob Galanti told journalists.
"Mazuz gave his opinion to ministers that this decision is not legally defensible, that it cannot stand up to either Israeli or international law," he said.
Palestinians were deprived of land often just on their doorstep
Many of the Palestinian "absentees" affected by implementation of the 55-year-old law are cut off from their land by new structures like roads to Jewish settlements and Israel's separation barrier, which has been deemed illegal by the International Court of Justice.
The law was originally devised to expropriate property belonging to the hundreds of thousands of Palestinians who fled their homes during the conflict that accompanied the creation of Israel in 1948.
Israel captured East Jerusalem, the West Bank and Gaza from Jordan in the 1967 war.
It then expanded Jerusalem's municipal boundaries into the West Bank and annexed the enlarged eastern Jerusalem, a move not recognised internationally.