The Israeli authorities are planning to build three new Jewish settlements in East Jerusalem, an area regarded as occupied land under international law.
Settlements cut off East Jerusalem from the occupied West Bank
The plan, which has yet to receive final approval, would involve building about 20,000 homes.
The Palestinian chief negotiator, Saeb Erekat, said the plan destroyed efforts to re-start the peace process.
He said Israel had to choose between settlements or peace, but could not have both.
Yehoshua Pollak, Jerusalem's deputy mayor, said the intention was to create a contiguous Jewish residential area linking East Jerusalem with major West Bank settlement blocs.
Israel has occupied East Jerusalem since 1967. It annexed the area in 1981 and sees it as its exclusive domain.
This has not been recognised by the international community. Palestinians hope to establish the capital of their future state in the East Jerusalem.
All settlements are considered illegal under international law - although Israel disputes this.