Israel holds Hamas responsible for a deadly suicide bombing in Tel Aviv but will not hit back against the Palestinian Authority, officials say.
Tensions have risen between Israelis and Palestinians recently
A special cabinet meeting ended with agreement to increase security efforts but not launch a military strike.
Instead it backed plans to revoke the Jerusalem residency of several Hamas MPs, adding to the group's isolation.
Hamas described Monday's bombing by Islamic Jihad, which killed nine people, as an act of "self-defence".
The BBC's Caroline Hawley, in Jerusalem, says Israel seems to have decided for now not to embark on a collision course with the Hamas-led government.
2005 foreign aid: $1bn
Cuts in direct PA funding:
Japan: no new funds
New direct PA funding:
Total monthly bills: $170m
Deficit: approx $1.3bn
Three Hamas MPs living in East Jerusalem, occupied by Israel, appear set to have their residency permits revoked.
Borders between Israel, the West Bank and the Gaza Strip will also see increased security, reports said, but officials revealed few details.
Israeli forces also arrested more than 20 Palestinians in raids across the West Bank. The father of the Tel Avivi bomber was reported to be among those detained.
At the White House, President George W Bush said he deplored the attack, but he also urged restraint saying all parties should be "mindful of the consequences" of their actions.
Despite international criticism, Hamas has refused to retract its support for the suicide bombing.
"The reason behind this cycle is the continuation of the occupation and by the continued Israeli assaults against our Palestinian people," said Prime Minister Ismail Haniya,
"We say that ending this cycle and achieving stability, security and calm in this region is dependent on ending the occupation and the achievement by our people of their full rights."
Monday's attack at a falafel restaurant in Tel Aviv occurred during the Jewish festival of Passover.
Nine people died and more than 50 were injured.
Palestinian leader Mahmoud Abbas has condemned the attack.
However, a joint statement read by a masked militant at a news conference in Gaza City demanded that Mr Abbas apologise for his condemnation, reported AFP news agency.
The statement was signed by the Popular Resistance Committees and three cells of the al-Aqsa Martyrs' Brigades, an armed offshoot of Mr Abbas's Fatah faction.
Cuts and pledges
Japan has confirmed that it will halt new aid payments to the PA, adding to a financial crisis.
Japan, which has given $840m (£474m) to the PA since 1993, said it wanted to see Hamas adopt a more peaceful policy, but did not expressly link its decision to the Tel Aviv attack.
However, emergency aid - such as a payment last month of $6m (£3.4m) to the UN's World Food Programme - would continue, officials said.
Projects such as repairing roads and building residential homes are also likely to receive continued funding.
Both the US and the EU have already suspended aid payments to the PA, leaving the newly formed Hamas government unable to pay its workers and facing a financial crisis.
Qatar and Iran have each pledged $50m (£28m) in new funds.