According to the Israeli Army Radio, the US demanded that planning approval for the project, which is being developed by an American millionaire, be revoked.
Netanyahu's response places renewed focus on the strained ties between the allies over the settlements issue.
Speaking on a visit to India on Sunday, Hillary Clinton, the US secretary of state, said Washington was trying to reach an agreement with Israel on settlements.
"The negotiations are intense. They are ongoing," she said.
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, a senior 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 consider 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.
Although Netanyahu recently yielded to US pressure to conditionally endorse the establishment of a Palestinian state, he has consistently resisted US demands for a total freeze on settlement expansion.
|The US has reportedly demanded approval for the East Jerusalem project be revoked [AFP]
Speaking to Al Jazeera, Akiva Eldar, the chief political columnist for 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 it's not helpful ... but no country, not even the United States, has recognised [Israel's] annexation of East Jerusalem."
Israel annexed East Jerusalem and declared the whole city its capital after the 1967 Middle East war.
Ziad al-Hammouri, the director of the Jerusalem Centre for Social and Economic Rights that provides legal assistance to Palestinian residents of East Jerusalem, 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."