The announcement drew outrage from the Palestinians and condemnation from Joe Biden, the US vice-president who is on a visit to the region partly to throw his weight behind US-brokered "proximity" talks between the Israelis and Palestinians that were announced just on Sunday.
Biden reiterated on Wednesday that Israel's move "undermines" the trust needed for negotiations.
Speaking to Al Jazeera in the occupied West Bank, Biden explained why he condemned the move.
"The Palestinians and the Israelis had just agreed to begin proximity talks, hopefully leading to an agreement, a final agreement.
"It is so easy to focus on everything that's wrong in a relationship but when I speak to all these folks and my old friends, Mr Abbas and Mr [Salam] Fayyad and Mr Netanyahu, all these folks and old friends ... when you speak to them individually, the truth is that they're not far apart.
"This is a time when we should be building trust because I am absolutely convinced there's a desire on the part of the parties to move forward. They know the status quo is helpful to neither of them.
"Everyone knows the Palestinians deserve an independent state, the Israelis deserve an independent and secure state and for those kinds of actions to occur when there's more agreement than disagreement is just destabilising."
Israeli officials apologised for embarrassing Biden with the timing of the announcement and aides to Binyamin Netanyahu said the Israeli prime minister had been caught unawares by the project's announcement.
Eli Yishai, the Israeli interior minister from the Shas party, said there was "certainly no intention to provoke anyone, and certainly not to ... hurt the vice-president of the United States".
But he admitted that final approval for the project would take another few months and the timing of the announcement "should have been in another two or three weeks".
'Building will continue'
Ofir Gendelman, who was recently appointed spokesman to the Arab world for the Israeli prime minister's office, told Al Jazeera that the announcement was "first and foremost" an embarrassment to Netanyahu.
|Moussa declared that 'insults have reached a point that not a single Arab could accept' [AFP]
Netanyahu, however, has given no indication that he intends to reverse the construction decision.
Gendelman said that "it is difficult to handle a coalition government in a vibrant democracy, especially in ours where you have so many players".
"You have parties that are for the peace process ... and you have other parties like Shas that control the interior ministry that is … more conservative on the peace process," he explained.
The government "is very interested in promoting the peace process and there has been a complete freeze of building the settlements in the West Bank", he said, but added that "Jerusalem is a totally different issue" and "building in Jewish neighbourhoods in Jerusalem will continue".
"This specific neighbourhood exists for more than 20 years and has more than 15,000 people. Now this is not located in an Arab neighbourhood and it is not a provocation. This is building inside the capital of the state of Israel and this neighbourhood will remain part of the capital of the state of Israel in any deal with the Palestinians."
Tuesday's announcement of new Israeli illegal settlement building was the second in as many days on land the Palestinians claim for a future state.
It also approved the construction of 112 new apartments in the West Bank settlement of Beitar Illit on Monday as Biden began his four-day visit to the region and just a day after the Palestinians agreed to the indirect talks with Israel.
Moussa declared on Wednesday that "insults have reached a point that not a single Arab could accept".
"Our position now is we reject the Israeli message. Abu Mazen [Abbas] is not ready to enter talks; it's useless." he said, adding: "The talks have already stopped."
Moussa added that the Arab League's backing, given last week for four months of "proximity" talks, was now under reconsideration and Arab ministers would meet in a few days to make a decision.
An Arab League statement said "the proposed talks are irrelevant" because of "the failure to halt Israeli actions which are changing the population structure and geographic composition of the occupied Palestinian territories, including East Jerusalem, and to withdraw the announcement for the construction of hundreds of settlements in occupied Jerusalem".