The FBI is investigating an analyst, named by US media, who is suspected of passing secret documents about Iran to Tel Aviv.
The US Defence Department confirmed on Saturday that the FBI was questioning a high-placed official suspected of spying for Washington's close ally but did not name him.
The Washington Post's website, however, quoted two sources who identified the alleged spy as Larry Franklin, a desk officer in the Defence Department's Near East and South Asia Bureau.
The sources said Franklin worked at the Defence Intelligence Agency before moving to the Pentagon's policy branch three years ago and is nearing retirement.
The suspect is closely associated with two pro-Israeli senior White House officials: Under Secretary of Defence for Policy Douglas Feith, with whom the alleged spy works, and Deputy Defence Secretary Paul Wolfowitz.
The Post and the New York Times both quoted unnamed officials as saying the analyst was suspected of passing classified documents to Israel via the American Israel Public Affairs Committee (AIPAC), the powerful pro-Israel lobby in Washington.
But the Israeli Embassy has denied the allegations. "They are completely false and outrageous," an embassy spokesman said.
Officials at AIPAC called the charges "baseless and false".
The fact that the alleged spy is associated with Feith and Wolfowitz may prove embarrassing for the White House. Both officials, actively involved in planning the invasion of Iraq, have been accused of promoting the war to serve Israeli interests.
The suspect works for pro-Israel
senior official Douglas Feith (L)
Before the invasion of Iraq in April 2003, Feith created a special intelligence unit that tried to prove Iraq's ties to al-Qaida - a link that has been almost universally discredited.
In 1996, Feith endorsed a policy document issued by a Jerusalem-based thinktank that called for the toppling of Saddam Hussein to further Israeli security interests.
The news was first broken by CBS News on Friday, which quoted federal agents saying the spy may have been in a position to influence the Bush administration policy on Iran and Iraq.
"The FBI has a full-fledged espionage investigation under way and is about to ... roll up someone agents believe has been spying not for an enemy but for Israel, from within the office of the secretary of defence," the network said.
It said the FBI believed it had solid evidence that the suspected mole supplied Israel with classified material that included secret White House deliberations on Iran.
The network described the spy as "a trusted analyst" assigned to a unit within the defence department tasked with helping develop the Pentagon's Iraq policy.
If proved, this would not be the first case involving an Israeli spy in the US. In 1986, a navy analyst, Jonathan Pollard, was jailed after he was found guilty of spying for Israel.
Pollard is believed to have provided Israeli intelligence with names of important American agents inside the former Soviet Union and Russia.
A number of key CIA agents in the eastern bloc were allegedly executed as a result of Pollard's spying.