Until now the US had demanded the freezing of all building on land occupied in the 1967 Middle East war.
Such building is seen as illegal by almost every country although Israel disputes this.
But the Bush administration signalled flexibility on Saturday on limited growth in West Bank settlements, to help embattled Israeli Prime Minister Ariel Sharon as he tries to get a plan for withdrawal from occupied Gaza past his far right opponents.
"I do not believe that America says now that settlements can be expanded. This thwarts and destroys the peace process," Palestinian Prime Minister Ahmad Quraya said.
Palestinians - who fear uprooting the Gaza settlers is a cover for strengthening Israel's hold on bigger West Bank enclaves -said the US was shredding its own peace "road map", a blueprint for a Palestinian state that has been stalled by violence.
A senior US administration official, commenting on Israel's plan to build 1000 more settler homes said on Saturday: "There is some flexibility there."
Palestinian PM Ahmad Quraya is
dismayed at US policy change
While the White House denied any official change in the US stance, an official said efforts were under way to clarify with the Israelis what "settlement activity" meant.
Based on this new understanding, officials said Washington could agree to new construction provided it did not take place outside the boundaries of existing settlements in undeveloped parts of the West Bank.
A senior Israeli source said there was a clear understanding the US was trying to help Sharon push through his plan for "disengagement" from nearly four years of conflict with the Palestinians.
"This is crucial for Sharon to get through the disengagement plan. He needs it for the Israeli public and his party. The Americans understand that," the source said.
Accepting limited construction within existing settlements could also benefit President George Bush, who would not want to cross Jewish-American voters who back settlements and other conservative supporters of Israel in the run-up to the November election.