The committee said the embargo had forced Hamas to look elsewhere for financial support.
The report said: "Hamas now has closer links to governments like that of Iran than it had two years ago. We doubt whether this is a development that the international community would have intended."
It said the embargo had left more than half of Palestinians without a reliable food supply and forced 66 per cent of Palestinian families into poverty.
The document highlighted Israeli actions such as the expansion of settlements on occupied territory, the continued construction of a separation barrier and separate roads, and restrictions on Palestinian access and movement.
It concluded all such measures continued to harm the economic prospects of a future Palestinian state.
The committee urged countries to hold Israel to its promise of implementing an agreement with Palestinians, dating back to November 2005, to facilitate the movement of people and goods within the Palestinian territories.
It recommended that in order to put pressure on Israel, Britain should push the EU to consider suspending its association agreement, a preferential trade pact with Israel, until there are improvements in access arrangements.
The committee also concluded that the temporary international mechanism [TIM], created to provide aid directly to the Palestinians while the boycott of Hamas continues, was not a suitable solution.
"It is pitiful to witness the bloody scenes in Gaza between the brothers"
The report said: "The TIM was a timely response to the crisis ... but is insufficient to cope with it. Increasing donor assistance is not the answer to the problems facing the Palestinians."
The EU spent $880m on aid to the Palestinians in 2006, of which $260m went through the mechanism, according to foreign office figures.
Britain channelled $140m through the TIM last year.
Malcolm Bruce, chairman of the committee, said it was not enough for Britain to hold its breath and hope for a breakthrough in the peace process.
"Over history we've spoken to terrorist organisations like the IRA. That kind of contact has to happen [with Hamas]," he said.
A foreign office spokesman declined to comment on the report.