Israel on Tuesday hotly defended its new construction plans for disputed east Jerusalem against criticism from President Barack Obama, Palestinians and the European Union insisting it never agreed to halt the building and sharpening a crisis that threatens to derail peace talks.

A harsh statement from Prime Minister Benjamin Netanyahu's office insisted that "Jerusalem is not a settlement. It is the capital of the state of Israel."

It continued: "Israel sees no link between the peace process and its development plans in Jerusalem."

The statement followed denunciations of a plan to build 1,300 apartments in Jewish neighbourhoods in east Jerusalem, which the Palestinians regard as illegal settlements.

Palestinians claim east Jerusalem, captured by Israel in the 1967 Mideast War, as the capital of their future state. The international community has not recognized Israel's annexation of the city's eastern sector.

The latest flare-up in the settlement issue has underlined its potential to scutfle US efforts to broker a peace accord. Palestinians see the settlements as a threat to their hopes for a state that would encompass West Bank, Gaza Strip and east Jerusalem, and charge that the continued construction is solidifying Israel's presence there. Settlers say openly that their goal is to prevent creation of a Palestinian state.