The dispute over East Jerusalem - home to Jewish, Muslim and Christian holy sites - is the most intractable issue in the Israeli-Palestinian conflict.
Israel captured the area in the 1967 Six Day War, immediately annexed it and claims all of the city as its eternal capital. But the annexation has not been internationally recognised.
"The Israelis have a right to live in Israel, the Palestinians have a right to live in Palestine"
Jean Asselborn, Luxembourg foreign minister
A first draft of a statement drawn up by the Sweden ahead of an EU leaders summit later this week spoke in favour of "a viable state of Palestine comprising the West Bank and Gaza and with East Jerusalem as its capital."
But a later version of the draft text is believed to drop the explicit reference to east Jerusalem as the capital of a future Palestinian state.
"A way must be found, through negotiations, to resolve the status of Jerusalem as the future capital of two states," a revised text, seen by the AFP news agency, said.
Marwan Bishara, Al Jazeera's senior political analyst, said: "It [the later draft] was watered down in a way that is apparently, for the time being, not acceptable for the Palestinians.
"Originally the draft will have said that East Jerusalem is the capital of the Palestinian state, that is a clear formulation that says on the 1967 borders East Jerusalem would be the capital of the Palestinian state.
"Now apparently they are calling for sharing East Jerusalem as two capitals of two states, now that would give Israel the leeway to redraw East Jerusalem as it wishes, which means we're back at square one."
Most EU ministers appeared supportive of the latest draft, but some said the declaration should not antagonise the situation and risk undermining efforts to restart peace talks.
Jean Asselborn, Luxembourg's foreign minister, asked "why Israel does not accept that Palestine consists of the West Bank, Gaza and East Jerusalem".
"The Israelis have a right to live in Israel, the Palestinians have a right to live in Palestine," he said.
Alexander Stubb, the Finnish foreign minister, said the EU must affirm its stand
on the status of Jerusalem and insist that Israel must not resume settlement
"The EU has very strong principles and we have to stick to those principles,'' he said.
"I think the negotiations, the peace process must simply start and this is a way forward."
On Monday Tzipi Livni, the Israeli opposition leader, called the text "a mistake" in an interview with French newspaper Le Parisien.
"If it is in the interests of both parties to resume dialogue, it is up to them to take the decisions, not the European Union," she said.