The decision was announced by Ehud Olmert, the acting prime minister of Israel, on Monday.
"It must be made very clear, we are not going to transfer funds which could finance terrorist attacks against our civilians," Olmert said on public radio.
Israel was due to hand over $35 million to the Palestinian Authority on Wednesday.
It decided to cancel the transfer after the stunning victory by Hamas, the Islamist resistance group, in Palestinian legislative elections last week.
Hamas, responsible for most of the anti-Israeli suicide attacks during the current Palestinian intifada, or uprising, has refused to disarm and espoused the destruction of Israel as part of its charter.
The blocked funds essentially correspond to sales tax revenues and customs duties levied on imported products coming into the Palestinian territories and crossing Israel.