A confidential report written for European Union foreign ministers has criticised Israel's policy on East Jerusalem, newspaper reports say.
The Israeli security barrier will cut off Jerusalem from the West Bank
The document, written by British officials, accuses Israel of rushing to annex Arab areas to prevent them becoming a future Palestinian capital.
Israel questioned the EU's attitude to the peace process and insisted Jerusalem would remain a united city.
The report was presented to an EU Council of Ministers meeting on Monday.
Prime Minister Tony Blair's official spokesman said it was an EU document "drawn up as part of the European Union process, reflecting not just British views but the collective views of the head of missions in Jerusalem".
He said it was "still being discussed and finalised".
'De facto annexation'
The report by the British consulate in East Jerusalem warned that Israeli actions reduce the already receding prospects for an eventual two-state solution.
"Israeli activities in Jerusalem are in violation of both its Roadmap (peace plan) obligations and international law," reports in the UK's Guardian newspaper quoted the document as saying.
The New York Times quoted the report's warning that Israel's policies "are reducing the possibility of reaching a final-status agreement on Jerusalem that any Palestinian could accept".
The report also concluded that the barrier being built by Israel in the West Bank was being used to expropriate Arab land and to keep the proportion of Palestinians in Jerusalem at no more than 30% of the total. Israel says the barrier is needed for security reasons.
"This de facto annexation of Palestinian land will be irreversible without very large-scale forced evacuations of settlers and the rerouting of the barrier," the report said.
"When the barrier is completed, Israel will control all access to East Jerusalem, cutting off its Palestinian satellite cities of Bethlehem and Ramallah, and the West Bank beyond. This will have serious... consequences for the Palestinians."
The report also warned that Palestinians in Jerusalem were deeply alarmed about the status of the city.
"They fear that Israel will 'get away with it', under the cover of disengagement. Israeli measures also risk radicalising the hitherto relatively quiescent Palestinian population of East Jerusalem."
EU plays down report
BBC Middle East analyst Roger Hardy says the European Union officials would much rather be celebrating the imminent opening of the Rafah crossing, between Gaza and Egypt, than engaging in verbal sparring with the Israelis over Jerusalem.
They are accordingly playing down the significance of the report.
These European concerns will not come as any surprise to Israeli officials, our correspondent says.
What will concern them, however, is the report's recommendation that European diplomats renew their contacts with Palestinian ministers in East Jerusalem - a move the Israelis would see as highly symbolic.
But for the moment it seems EU foreign ministers have not decided what their response to the report will be.
The council of ministers agreed at the meeting on Monday to put the issue on hold until next month.
Israeli Foreign Ministry spokesman Mark Regev insisted his country would not change its stance.
"The Israeli position is public and known. We say Jerusalem will be the united capital of Israel in the framework of a final peace deal," Mr Regev told the AFP news agency.
"We're hopeful that Europe will continue to move forward in its attitude to the Israel-Palestinian issue and not return to the more one-sided approach that we've seen in the past."