Demolition work had begun on the Cinema Jenin after it failed to attract enough customers in recent years, said Marcus Vetter, one of those behind the 2010 relaunch supported by rock musician Roger Waters and human rights campaigner Bianca Jagger.
The cinema, the last in Jenin in the northern West Bank, was also used as a cultural centre and theatre but is now expected to be replaced by a mall.
"It is a very disappointing and sad moment," Vetter, a German director, told AFP, explaining the heirs of the original owners had sold it for about 1.7 million euros ($1.8 million).
Built in 1957, Cinema Jenin was considered to be one of the largest and most impressive cinemas in the Palestinian territories but it shut down after the first intifada, or uprising, against Israel began in 1987.
The 2010 relaunch was the brainchild of Vetter and Ismael Khatib, a Palestinian who donated his 11-year-old son's organs to save Israeli children after the boy was shot dead by an Israeli soldier in 2005.
Khatib had made the gesture in an effort to promote peace efforts, but it was viewed as controversial by some Palestinians.
At the time the 335-seater cinema received celebrity backing, including a state-of-the-art sound system paid for by a 100,000 euro ($106,000) donation from Waters, a long-time pro-Palestinian campaigner.
Conservative attitudes and fears
Jagger attended the launch, which was hailed as a major moment for culture in the Palestinian territories.
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Jenin, a conservative Muslim city, was a major base for the two Palestinian intifadas against Israel, the most recent of which ran from 2000-2005.
Juliano Mer-Khamis, a well-known actor from a mixed Jewish-Arab Israeli family who himself had been involved in the cinema, was shot dead in the city in 2011 by unknown gunmen.
Asked why the cinema failed to attract clients, Vetter said it was a mixture of conservative attitudes and fears that going to this specific theatre amounted to accepting Israel's nearly 50-year occupation of the West Bank.
"People were not ready to really go there. They were also maybe a little bit scared how it would be perceived if they go."
In 2012, the Israeli left-wing newspaper Haaretz said rumours of a so-called "lack of modesty" at a neighbouring guesthouse where volunteers stayed also damaged the cinema's reputation.
Dina Aseer, a leader at a local arts centre, said they used the cinema to teach young people Dabke, a national dance.
"We have a band of 25 and a Dabke school of 150 students and no place to go," she told AFP. "Cinema Jenin was our home."
Despite the closure, Vetter said he did not regret the project.
"You cannot imagine how much work it was to bring all the equipment there, to find the finance, to fight for it," he told AFP Wednesday.
"It was the story of a dream. And at least it's there, the story happened."