Ehud Olmert's announcement came a day before a team of US envoys were scheduled to arrive to help resolve the dispute.
Olmert told Condoleezza Rice, the US secretary of state, in a phone conversation on Tuesday that cabinet would vote on the matter at its weekly meeting on Sunday, a statement from Olmert's office said.
Rice called Olmert for an update on the condition of Ariel Sharon, the Israeli prime minister who was hospitalised after a massive stroke.
If the cabinet approves the plan, it would resolve a dispute that threatened to derail the 25 January election.
Israel had threatened to prevent the voting in Jerusalem, which had been allowed in previous elections, because of the presence on the ballot of Hamas, a Muslim group pledged to the destruction of Israel.
A cabinet decision to allow the voting to go forward would be contingent on Hamas not participating, Olmert's statement said.
Israeli officials gave conflicting accounts as to whether the proposal would pass.
Shaul Mofaz, the defence minister, said on Tuesday that Israel would allow Jerusalem voting along the same lines as previous Palestinian elections, when it permitted some residents to cast absentee ballots in local post offices.
Israeli police have ended a ban
on campaigning in Jerusalem
The remainder of voters cast ballots in outlying West Bank suburbs. "Israel's policy regarding elections in East Jerusalem will stay like it was," Mofaz said while on a tour near Jerusalem.
But Silvan Shalom, the Israeli foreign minister, said there would be no voting in Jerusalem. "Israel is of the opinion - and it was an opinion widespread when Prime Minister Sharon was still functioning as a decision-maker - that under the present circumstances, residents of East Jerusalem are not to be allowed to vote in Jerusalem itself but only in the adjoining (West Bank) villages," he said.
Saeb Erekat, the Palestinian negotiator, said he had not heard anything official from the Israelis. "If this is the case, I welcome this position of the Israeli government," he said.
On Tuesday, Israel's security cabinet recommended that the government boycott elected Hamas representatives unless the group accepts Israel and lays down its weapons, said security officials speaking on condition of anonymity.
Israel wants Hamas to accept its
existence and lay down weapons
Israeli police also reversed a ban on allowing Palestinian candidates to campaign in Jerusalem.
On Tuesday, police published conditions for the campaigning, saying that members of armed groups, such Hamas or Islamic Jihad, were still banned.
Other candidates could hold meetings in private homes, but assemblies in public buildings would require a police permit.