"To put a fine point on it, Jerusalem is not a settlement."
The Palestinians want occupied East Jerusalem as their future state capital.
Brown said that he was "increasingly confident" of progress on Middle East peace after talks with Netanyahu, whom he called "a leader of immense courage".
"The Palestinian economy must be allowed to flourish so I strongly welcome his recent moves to remove checkpoints in the West Bank," Brown said.
"We also discussed the issue of settlements in East Jerusalem. I made it clear that settlement activity was a barrier to a two-state solution."
Yet, he said: "I am increasingly confident, however, that there is a genuine will to make progress, that a freeze of such activity would result in meaningful steps towards normalisation from Arab states."
Mahmoud Abbas, the Palestinian president, has previously said that a freeze on all Israeli settlement construction in the Occupied Palestinian West Bank is a condition for renewing peace talks with Israel. Talks have been at a standstill since last December.
The Israeli government last week said that they would put a hold on introducing new settlements. However, the watchdog Peace Now has said that building has continued at the same pace since the announcement, through illegal construction or fulfillment of previous plans.
Alan Fisher, Al Jazeera's correspondent in London, said: "What is clear is the Israelis are going in with a very definite agenda. They are not going to turn round and stop the settlements unless they get something in return. It's part of the negotiating stance they're taking.
"What Netanyahu has said is that he wants to see a demilitarised Palestinian state, and that's not won a lot of support among Arab backers.
"But what the Americans are gambling on is if they can get an end to the settlements, they can point to that as some sort of progress and perhaps bring the Palestinians to the table to start discussing.
"But it's going to be incredibly hard to make peace in the Middle East, particularly at the moment."
Netanyahu's talks in the UK - which also included discussions on Iran's nuclear programme - are part of a three-day Europe tour.
On Thursday he is due to meet Angela Merkel, the German Chancellor.