A spokesman for Ariel Sharon, the prime minister, said on Wednesday Israel will not allow voting in Jerusalem for the poll on 25 January because Hamas, which calls for Israel's destruction and has spearheaded a bombing campaign, is running for the first time.
Raanan Gissin said: "There is no reason whatsoever we should assist a terrorist organisation on the ballot to gain victory. This would be like letting a Trojan horse into our city."
Israel allowed Palestinian residents of East Jerusalem to vote in Palestinian Authority elections in 1996 and earlier this year when Mahmoud Abbas was elected president.
Palestinian officials said the election may be delayed if Israel prevents voting by East Jerusalem residents.
Nabil Shaath, a senior Palestinian official, said: "We cannot hold elections anywhere if the Palestinians in Jerusalem are not allowed to vote."
Abbas denounced Israel's decision saying "this is a very dangerous situation", adding that he would "study" the issue.
The US predicted the sides would find a solution to the voting in Jerusalem and said the Palestinians could still hold the election on time despite Israel's move.
Israel has asked Egypt to use its
influence to curb rocket attacks
Sean McCormack, a spokesman for the State Department, said: "At this point, we see no obstacles to those elections taking place as scheduled on January 25th with concerted effort and focus on the part of the Palestinians to see that those elections take place."
A Hamas spokesman said the group, which is expected to make a strong showing in the poll, demanded it be held on time. He would not specify whether that position would remain the same if East Jerusalem Palestinians could not vote.
Palestinian residents of East Jerusalem carry Israeli identity cards, but see themselves as the citizens of a future Palestinian state with East Jerusalem as its capital.
Abbas has repeatedly said he does not want to postpone the vote, but has been under pressure for a delay from some Palestinian officials due to a split in his ruling Fatah movement.
Hamas's corruption-free reputation and extensive charity network mean its popularity is rising among Palestinians.
Its strong showing in the first three rounds of municipal elections in the West Bank and Gaza Strip, winning in several major cities including the Fatah stronghold of Nablus, has prompted concern, in Israel and elsewhere, about a Hamas victory.
A Sharon aide said a Hamas win
would be the peace process's end
Israel's Yedioth Ahronoth newspaper said Palestinian leaders, Israelis and foreign mediators were seeking a reason to delay the election in order to prevent a possible Hamas win. It said Israel's policy on East Jerusalem might serve that purpose.
Gissin, Sharon's spokesman said: "If Hamas gains victory, that would mean the end of the political (peace) process. It would also, I'd regrettably say, be the end of the Palestinian Authority as the sole sovereign power of the Palestinians."
Israel says all Palestinian political activity in East Jerusalem was banned under the 1993 interim Oslo peace accords.
Palestinians dispute this and say Jerusalem residents should play an active role in Palestinian affairs.
Israel captured East Jerusalem in the 1967 Middle East war and annexed it in a move not recognised internationally. It sees the eastern part of the holy city as part of its "eternal and indivisible capital".