"We cannot accept the fact that Jews wouldn't be entitled to live and buy anywhere in Jerusalem," Netanyahu declared, calling Israeli sovereignty over the entire city "indisputable".
Granted by the Jerusalem municipality earlier this month, the planning approval for the controversial project allows the construction of 20 apartments plus a three-level underground parking lot that will replace the Shepherd Hotel.
The old hotel lies in the Palestinian neighbourhood of Sheikh Jarrah, where settlement building is illegal under international law.
Saeb Erekat, the chief Palestinian negotiator, said: "If the Israeli prime minister continues with settlement activities, he will undermine the efforts to revive the peace process."
Most international powers also considers Jewish neighbourhoods in East Jerusalem to be settlements and an obstacle to Israeli-Palestinian peacemaking.
Settlements have emerged as a major sticking point in relations between Israel and the administration of Barack Obama, the US president, because of their potential to disrupt Middle East peacemaking.
Although Netanyahu recently yielded to US pressure to conditionally endorse the establishment of a Palestinian state, he has consistently resisted US demands for an immediate freeze on settlement expansion.
Speaking to Al Jazeera, Akiva Eldar, chief political columnist for the Israeli newspaper Haaretz, said the dispute was an example of how settlement building had become a publicly acknowledged obstacle to the peace process.
"I think the high profile that both Israel and the United States, as well as the Arab countries and particularly the Palestinians, have put on the settlements is offering a good potential for a head-on collision," he said.
"According to the official Israeli position, it's not illegal and even the United States, for many years, and even now, is not making a point of the legal issues, they're just saying its not helpful ... but no country, not even the United States, has recognised [Israel's] annexation of East Jerusalem."
Israel annexed East Jerusalem and declared all of the city its capital after the 1967 war.
Ziad al-Hammouri, the director of the Jerusalem Centre for Social and Economic Rights, told Al Jazeera: "What's happening in Jerusalem today ... is illegal. East Jerusalem is a part of the occupied territories which has to be given back and form part of a Palestinian state."
The centre provides legal assistance to Palestinian residents of East Jerusalem.