One of the suspects, Yitzhak Pas, is the father of a 10-month-old girl shot dead by a Palestinian gunman in the West Bank city of Hebron two years ago.
Prime Minister Ariel Sharon's office said on Friday that seven bricks of explosives stolen from the army were found in Pas's car when he was stopped at a roadblock last month.
Pas's brother-in-law, Matityahu Shvu, was also in the vehicle at the time and was arrested.
The men are suspected of involvement with a six-member Jewish cell indicted for planning a bombing attack on a Palestinian girl's school in East Jerusalem in April.
However, Pas says he is innocent.
"Whoever is inventing all sorts of (Jewish) underground groups should deal instead with Israel's real enemies," he said.
And Naftali Wertzberger, a lawyer for the two suspects, claimed the men were set up.
Sharon: settlement architect
"In the end, it's all about a few bricks of explosives that someone stole from the army and put in Pas's car to frame him," he said.
The settlement project began after the Arab-Israeli war of 1967, when Israel seized the West Bank and Gaza territories from Jordan and Egypt.
The activity during the 1970s was largely led by Mr Sharon who was then a government minister.
Since the 1993 Oslo peace accords, the number of Jewish settlers has increased by 70%, not counting the 200,000 Israelis living in 11 settler quarters in East Jerusalem.
A number of "illegal outposts" have been built very close to refugee camps, where Palestinians live cheek-by-jowl in squalor and under constant threat of abuse and violence from the heavily armed settlers.