The latest development is in a flashpoint area of East Jerusalem
Palestinians have condemned the latest plans for more Jewish homes in East Jerusalem, announced as Israeli PM Benjamin Netanyahu ended a US visit.
Palestinian negotiator Saeb Erekat said Israel was "digging itself a hole", while an Israeli MP said Mr Netanyahu had "decided to spit into Obama's eye".
The announcement came as Barack Obama and Mr Netanyahu held unusually low-key talks at the White House on Tuesday.
The trip was overshadowed by the worst crisis in US-Israeli ties for decades.
The row flared two weeks ago when, during a visit by US Vice-President Joe Biden, Israel unveiled plans to build 1,600 homes in part of East Jerusalem.
Mr Netanyahu said he regretted the bad timing of the earlier announcement, but Washington branded it an insult.
Minutes before Mr Netanyahu's fence-mending visit to the White House on Tuesday, it emerged the Jerusalem municipal government had approved the building of 20 new apartments.
The project has been funded by American millionaire Irving Moskowitz, a patron of Jewish settler groups.
The development is planned for the site of an old hotel in occupied East Jerusalem's Sheikh Jarrah area, a flashpoint neighbourhood.
Palestinian chief negotiator Saeb Erekat said it cast doubt on Israel's credibility as a peace partner.
"Israel is digging itself into a hole that it will have to climb out of if it is serious about peace," he said.
Washington said it was seeking clarification on the latest plans.
But Israeli MP Eitan Cabel - a member of the Labor Party, which sits in the governing coalition - accused Mr Netanyahu of a fresh insult to the US.
"Netanyahu decided to spit into Obama's eye, this time from up close," Mr Cabel was quoted by the Associated Press news agency as saying. "He and his pyromaniac ministers insist on setting the Middle East ablaze."
The Israeli anti-settlement watchdog, Peace Now, which discovered the latest building plan, said it could prove "devastating" for hopes of resuming peace talks, stalled for more than a year.
But an Israeli Likud MP, MK Yariv Levin, was quoted as saying the building approval was the "translation of Netanyahu's words into deeds".
It was an apparent reference to Mr Netanyahu's speech on Monday to an influential pro-Israeli lobby group in Washington, when he reasserted Israel's "right to build" in Jerusalem.
The Israelis said there had been a "good atmosphere" during Tuesday's talks between Mr Netanyahu and Mr Obama.
Paul Wood, BBC News, Jerusalem
The final building permits for the Shepherd Hotel development in East Jerusalem came through just a few hours before Benjamin Netanyahu's meeting with President Obama. Mr Netanyahu has supposedly put in place a procedure - involving the vetting of announcements by senior officials - to prevent such embarrassments. Clearly it is not working.
Israeli officials will no doubt, once again, try to portray this as a low-level bureaucratic decision which has no relationship to the high diplomacy between Israel and the US. Since the US has protested about this project, small as it may be, before, that is not really credible.
This may have come about - as with the Ramat Shlomo announcement - because right-wingers are seeking to make themselves look good to their own supporters by making Mr Netanyahu look bad. Conversely, sources in the Jerusalem municipality have accused the Israeli left of publicising the new building permits in order to "rekindle the situation on the ground".
But the BBC's Kim Ghattas in Washington notes the Israeli leader did not get the reception usually reserved for America's allies.
There was no press conference, no lavish welcome, and the White House did not even release a picture of the meeting.
It all signals that the US is playing tough, making clear it is upset with the Israeli government, says our correspondent.
Last week Mr Obama said the approval of the plans for 1,600 homes in the Ramat Shlomo area of East Jerusalem was not helpful to the peace process.
Palestinians want East Jerusalem for their future capital, but Israel insists the city cannot be divided.
Nearly 500,000 Jews live in more than 100 settlements built since Israel's 1967 occupation of the West Bank and East Jerusalem.
They are considered illegal under international law, although Israel disputes this.
The row also comes amid frayed ties between Israel and Britain.
London announced on Tuesday it was expelling an Israeli diplomat over the forgery of British passports used by the suspected killers of a Hamas commander in Dubai.
POINTS OF TENSION IN JERUSALEM
1 Gilo: 850 homes approved for publication and planning objections in Nov 2009
2 Pisgat Zeev: 600 homes approved for publication and planning objections in Jan 2010
3 Sheikh Jarrah: Municipality approves the building of 20 new apartments on the site of an old hotel
4 Ramat Shlomo: 1,600 homes approved for publication and planning objections in Mar 2010
5 Silwan: Demolition orders on 88 Palestinian homes built without difficult-to-get permits - Israel planning controversial renewal project
6. West Bank barrier: Making Palestinian movement between West Bank and Jerusalem harder - Israel says it's for security