A spokesman for Israel's Transport Minister Meir Sheetrit said on Friday that the train project had received a green light from the attorney-general to route the line through the illegal Latrun and Mevasseret Zion settlements.
The attorney-general, Meni Mazuz, had held up planning on the line to study the legal implications of its crossing West Bank territory, but had now decided it could move forward, Transport Ministry spokesman Jonathan Beker said.
"The minister has been informed that there is not a problem that should stop the progress of the rail line," Beker said.
The announcement on Friday was immediately criticised by Palestinian representatives and raised questions about Israel's intentions for the occupied territory.
Palestinian cabinet minister, Saib Uraiqat, said any Israeli building in the territories occupied in 1967 is illegal according to international law.
"This rail route is part of an Israeli policy of creating a permanent occupation and this policy will undermine any possibilities of reaching a peace agreement," he said.
Israeli forces took control of the West Bank in the 1967 Middle East War, and its final status is supposed to await peace talks.
Besides its plans for the rail line, Israel is also constructing a separation barrier in the West Bank and Israel, which has illegally annexed a large part of the occupied territory.
Israel says the barrier is necessary to prevent Palestinian resistance from attacking Israelis, while Palestinians condemn it as a land grab.
Israeli officials have said the barrier is a temporary structure that could be dismantled if there is a peace deal with the Palestinians.
But Israel Railways, a public corporation, says the planned Tel Aviv-Jerusalem rail line is a permanent part of its infrastructure.
Beker said construction of the line would start after the ministry arranges financing and hires contractors. He did not provide a target date for completion of the project.