Expanding the Maale Adumim settlement would cut off Jerusalem from the West Bank, making it virtually impossible for the Palestinians to establish a future capital in the eastern part of the city.
In the past, Israeli-Palestinian peace talks have broken down largely due to the impasse over the fate of Jerusalem.
Bloodshed has also erupted over the city, home to shrines sacred to Judaism and Islam.
Palestinian officials on Friday welcomed the comments by Israeli Vice Premier Ehud Olmert, but said they have not been formally notified of a decision to suspend the expansion.
The chief Palestinian negotiator, Saeb Erekat, urged Israel to call off the construction altogether.
The US has repeatedly asked Israel not to expand West Bank settlements, in line with its commitment under the internationally backed road map peace plan, and specifically condemned the Maale Adumim expansion project.
As part of the project, Israel had planned to build some 3650 apartment units in a new neighbourhood that would connect the settlement of 30,000 residents to Jerusalem.
Olmert: In the end we will have
to build the [continuity] project
Only a few months ago, Israeli Prime Minister Ariel Sharon was quoted as saying Israel would move ahead with the project.
However, Olmert on Friday said the plan has been suspended.
"The state of Israel has committed itself to freeze the building," Olmert told The Jerusalem Post daily.
Olmert told the Post that Maale Adumim would eventually be expanded. "It is absolutely clear that at a certain point in the future, Israel will create continuity between Jerusalem and Maale Adumim, and so there is not even an argument that in the end we will have to build the project," Olmert said.
However, he added that Israel would not act unilaterally.
"When the conditions are ripe, we will raise the issue with the Americans again," he said. "It is clear we will not do anything behind the back of the Americans."
In a separate development, Israeli politicians on Friday criticised renowned pianist-conductor Daniel Barenboim after local media said he refused to answer questions posed by an Israeli Army Radio reporter in uniform.
Barenboim, an Argentine-born Israeli who lives abroad, has long ruffled feathers in Israel with his criticism of Israeli occupation of land Palestinians want for a state.
Argentine-Israel Barenboim has
frequently ruffled feathers
Israeli media said Barenboim rebuffed the female Army Radio reporter at a book launch in Jerusalem on Thursday because, as a soldier, she was dressed in military uniform and that he would agree to talk only if she wore civilian clothes.
The station is a military unit and employs both veteran civilian media personalities and young army recruits, many of whom go on to a career in the Hebrew media. It is one of Israel's most popular radio stations.