The Israeli government considers Gilo an integral part of Jerusalem
US President Barack Obama has said Israel's approval of 900 extra housing units at a settlement in East Jerusalem could lead to a "dangerous" situation.
Mr Obama told Fox News that additional settlement construction made it harder for Israel to make peace in the region and "embitters the Palestinians".
The settlement of Gilo has been built on land Israel captured in 1967.
The Palestinians have refused to attend peace talks until Israel stops building settlements on occupied territory.
The Israeli government disputes that East Jerusalem is occupied territory, and therefore refuses to include annexed areas as part of any accommodation of Mr Obama's past calls for "restraint" in settlement construction.
Nearly 500,000 Jews live in more than 100 settlements built on occupied territory.
The settlements are illegal under international law, though Israel disputes this.
In the interview with Fox News, Mr Obama stressed that Israel's security was "a vital national interest to the United States", but warned that its policies were complicating his administration's efforts to revive the peace process.
"I think that additional settlement building does not contribute to Israel's security, I think it makes it harder for them to make peace with their neighbours," he said.
"I think it embitters the Palestinians in a way that could end up being very dangerous," he added.
Israel Prime Minister Benjamin Netanyahu had reportedly rejected a request from Mr Obama to freeze the work at Gilo.
Palestinian Prime Minister Salam Fayyad said the settlement expansion, approved by the Jerusalem Planning Committee, showed Israel was not interested in restraint.
"Obviously this is completely unacceptable.
"There is no such thing as restraint when it comes to settlement activity. Either this stops completely or clearly it doesn't stop."
The European Union presidency, currently held by Sweden, added its criticism, saying settlement expansion would hinder the conflict's resolution.
"If there is to be genuine peace, a way must be found to resolve the status of Jerusalem as the future capital of two states," it said.
Israel demolished a Palestinian property in occupied East Jerusalem a day after the planning decision was publicised.
Palestinian reports said there were two homes and two commercial premises in the building.
Israeli officials commonly say that buildings they issue demolition orders for have been built without permission.
Palestinians say building permits are virtually impossible to obtain as they face discrimination by the Israeli authorities.