'Inseparable part of Jerusalem'
"This includes, first and foremost, Jerusalem," he said.
"We are building in Jerusalem because everyone knows that there is no chance the State of Israel will give up neighbourhoods like Har Homa, as you know. It's an inseparable part of Jerusalem."
Palestinians, who refer to Har Homa as Jabal Abu Ghneim, see the building there as the final piece in a wall of settlements encircling Arab east Jerusalem, cutting it off from the rest of the occupied West Bank.
"We are building in Jerusalem because everyone knows that there is no chance the State of Israel will give up neighbourhoods like Har Homa"
Palestinian negotiator Saeb Erekat said Olmert's comments "cannot stand" and that the Palestinians delivered that message directly to Israel's foreign minister and chief negotiator, Tzipi Livni.
"This is absolutely unacceptable," Erekat said.
Israel's move has drawn criticism from the US which said such construction was "unhelpful" to peace efforts while Palestinians accused Israel of undermining the talks.
Washington has been especially critical of Israeli plans to build hundreds of new homes in Har Homa.
Israel has rejected criticism of the Har Homa project, saying that the land was annexed and placed inside the city boundaries drawn after occupying the West Bank in 1967.
The annexation, however, is not recognised internationally.
Olmert's declaration cast a long shadow in Israeli-Palestinian negotiations which resumed on Monday.
Ahmed Qureia, the former Palestinian prime minister and now chief negotiator, said "after what the Israeli prime minister said about settlements, the meeting was an unofficial, not an official, meeting".
"I expressed our strong anger and complete rejection of this position," he said, adding that it violated Israel's commitment to the international road map peace plan.
An Israeli foreign ministry spokesman said Livni and Qureia "restarted their dialogue and met face-to-face for two hours", but
declined to comment on the discussions.
Monday's meeting was the first after the Palestinians suspended talks two weeks ago to protest against an Israeli offensive in the Gaza Strip which killed more than 120 Palestinians.
'Concern' over Iran
At a briefing on Monday, Olmert and Merkel, who is on a three-day visit to mark Israel's 60th anniversary, expressed a mutual commitment to end Iran's nuclear programme.
"We regard with grave concern, in a very similar way, the continuation of Iran's steps to develop nuclear armament," Olmert said at a joint press conference.
"Iran must show that it is not working on a nuclear programme"
Angela Merkel, German chancellor
"We are also joined in our acknowledgement that there is a need to continue to conduct a series of steps that will bring this development process to a halt."
Speaking after him, Merkel said Germany considered threats against Israel as "threats against us".
"We agree that we must do all we can to put as much pressure as possible on Iran, through [UN] Security Council measures and also through talks within the European Union."
She said Germany was hoping for a diplomatic solution over the Iran nuclear issue.
"We're counting on a solution in which as many [countries] as possible are included," she said. "Iran must show that it is not working on a nuclear programme."
Iran denies it is seeking atomic arms, and says its nuclear programme is to meet growing energy needs.
On Tuesday, Merkel will become the first German chancellor to address the 120-member Knesset, or Israeli parliament.