The building, which began on Sunday after being quietly approved by local authorities in recent months, coincided with the arrival of US envoy William Burns, who is in the region trying to revive the so-called "road map" for peace.
Bulldozers pushed ahead on Monday morning with road construction for the neighbourhood of Nof Zahave or Golden View, which will abut Jabal Mukabbir, a heavily populated Palestinian residential area close to the UN local headquarters.
According to Khalid Amayrah, Aljazeera correspondent in Palestine, the protesters were strongly opposed to "this settlement being built on land confiscated from private Palestinian owners."
Amayrah said the demonstrators were released a few hours later.
The settlement would eventually consist of 500 apartments, a hotel and schools, said Yehuda Levy, one of the project's sponsors.
"Building of the roads and other infrastructure started on Sunday," Levy said. "We have all the permits we need from the authorities."
Senior Palestinian negotiator Saib Uraiqat criticised the new settlement.
"We call on the Israeli government to stop these facts on the ground and opt for serious negotiations that will end this vicious cycle and lead to a two-state solution," he said.
Palestinian residents have already lodged an appeal with the Israeli courts against the construction work.
Israel seized east Jerusalem from Jordan in the 1967 war and later annexed the sector – along with other land to the north, east and south to the western sector.
About 220,000 Israelis now live in and around a dozen settlements in east Jerusalem.