The government invoked the 1950 Absentee Property Law last July and word leaked out this month, alarming Palestinians who feared an attempt to usurp their claims to East Jerusalem, which they want as the capital of a future state.
Israeli media said the move had angered the US administration, which regarded it as an obstacle to new peace prospects raised by the election of moderate Palestinian President Mahmud Abbas on 9 January to replace Yasir Arafat.
In a lengthy legal opinion, Attorney-General Menachem Mazuz told the government to cancel implementation of the law in East Jerusalem, saying it violated obligations under international law and was sure to be overturned by the Israeli supreme court.
'Law is illegal'
"This decision cannot stand," Mazuz said in a four-page ruling on the law, which allows a state custodian to seize East Jerusalem property belonging to Palestinians in the West Bank.
A justice ministry source said Mazuz had determined the law would not withstand supreme court appeals.
The separation wall has already
swallowed up tracts of land
"If the attorney-general says it [the law] won't stand up [to appeal], then it means that yes, this law is illegal," the justice ministry source said. The government was obliged to adhere to Mazuz's decision, the source added.
Officials at the finance ministry, which is responsible for implementing the law, and at Prime Minister Ariel Sharon's office, declined immediate comment.
Haaretz said the decision was approved at a 22 June meeting of the Ministerial Committee on Jerusalem Affairs attended by only two members, both rightists.
Since there were no opposing votes in the meeting, the decision was automatically approved by the government two weeks later without a cabinet vote or a notation in cabinet minutes.
Mazuz said that due to a bureaucratic mishap, he was not informed of the decision and only found out by chance when legal complaints were made to his office.
"The decision cannot stand"
He wrote that the ministerial committee had acted outside its powers and improperly applied the law, causing "numerous legal difficulties".
"These have to do with imposing the law and the reasonability of imposing it under these circumstances and with regard to Israel's obligation under international law."
Under the Absentee Property Law enacted two years after the country's founding, land belonging to people living in "enemy countries" was confiscated by the state.
The measure allowed confiscation of the property of hundreds of thousands of Palestinians who became refugees in the 1948 war and scattered mainly to Arab states.
While technically applied to East Jerusalem after Israel captured it in the 1967 Middle East war, the law was never implemented.
The decision raised hackles among Palestinians already worried by Israeli plans to demolish dozens of houses near its West Bank barrier as well as plans to require East Jerusalem residents to obtain permits to visit the West Bank.
Some Palestinian landowners, according to their lawyers, have already received notices that their plots in the city have been seized under the law even though they live nearby - just outside the city limits in the West Bank.