By Jonathan Marcus
BBC diplomatic correspondent
Israel's controversial proposal to build some 3,500 new homes in the West Bank comes just as final plans are being drawn up for a pull-out of all Israeli settlements from the Gaza Strip.
Israel plans to create two new neighbourhoods in the West Bank
A small number of settlements in the West Bank will also be removed.
Settlements are one of the major stumbling blocks in relations not just between Israel and the Palestinians but also between the Israeli government and Washington.
The dream of a biblical Greater Israel has already collapsed but the idea of a Greater Jerusalem is still very much alive.
The Israeli government's latest plans are to create two new neighbourhoods effectively linking the settlement block of Maaleh Adumim to East Jerusalem.
This will be taken by the Palestinians as yet another sign that Israel has no intention of relinquishing that part of the West Bank closest to Jerusalem.
And they argue that Israel's moves fly in the face of the so-called roadmap-to-peace agreement which calls for a total freeze on settlement-building.
The Israelis, however, believe that they have Washington's support for constructing thousands of new homes in the Jerusalem area.
A letter from President George W Bush to Israeli Prime Minister Ariel Sharon almost a year ago said that it was unrealistic to expect that a final peace deal would see Israel return fully to its old borders.
The settlement issue is complicated because while the Americans appear willing to accept some building activity in areas that they believe will remain under Israeli control they want a freeze on construction elsewhere, and they want so-called outposts - settlements not approved by the Israeli government - removed immediately.
Here the Israeli government has been dragging its feet. Indeed a recent official Israeli report found that illegal settlement construction was much more widespread than had been thought and in many cases had been aided by government officials or agencies.
But given all of Prime Minister Sharon's difficulties in pushing through the Gaza withdrawal, it is unclear how much pressure the Americans are likely to apply to make him honour his commitments on the wider settlement issue.