Wildcat outposts dot the West Bank, some consisting of just a few trailers and others of several mobile homes connected to the power grid.
Many are built as extensions to officially established settlements.
Ministers said the government would immediately end all funding and the provision of infrastructure for the outposts.
It was unclear exactly what support had been provided in recent years as direct funding contravenes government policy.
Olmert also proposed an increase in security personnel, arrests and timely trials to prevent settler violence.
The Israeli cabinet's move followed a warning by Yuval Diskin, the head of Israel's Shin Beth domestic intelligence agency, that extremist Israeli groups could use violence to thwart any deal to hand over the West Bank to the Palestinians.
"We discern a willingness among the far-right to resort to using guns in order to prevent progress in the diplomatic process"
Yuval Diskin, the head of Shin Beth's inetlligence service
"We discern a willingness among the far-right to resort to using guns in order to prevent progress in the diplomatic process," Diskin told the cabinet meeting.
But Diskin stopped short of predicting that settlers or their supporters would try to kill Israeli politicians.
His warning came as Israel marked the anniversary of the assassination of Yitzhak Rabin, the former prime minister killed in 1995 by an ultranationalist Jew who said he carried out the killing to halt land-for-peace efforts with the Palestinians.
Some settlers say they have adopted a "price tag" policy of attacking Palestinians or security forces every time one the outposts is demolished.
Dov Lior, the head rabbi of the Kiryat Arba settlement, compared Israeli security forces to "the Nazis in Poland" during World War II.
"The Nazis also woke people up in the middle of the night and deported them. At that time also we were driven from our homes for no reason other than that we were Jewish," he said.
The government referred directly to the rabbi's remarks in its decision to sever funding to the outposts, saying it would "examine whether state employees are involved in incitement and bring them to justice".
On Saturday, two police officers were slightly wounded after teenage settlers threw rocks near the West Bank town of Hebron.
A representative from the local settler council said the police had sparked the latest fighting by beating a 10-year-old settler child.
"The child wanted to cross a roadblock... Those who strike our children have to know that we won't turn the other cheek," Itamar Ben Gvir said.
But Moshe Pinchi, the border police spokesman, said he had no knowledge of the alleged beating and accused the settlers of "cynically" sending minors to attack the police.
More than 260,000 Israelis live in the more than 120 government-authorised settlements across the West Bank.
Another 200,000 live in mostly Arab east Jerusalem, which Israel seized and annexed in the 1967 Middle East War.
The international community considers all West Bank settlements to be illegal.