Israel's construction in east Jerusalem is a deliberate strategy to prevent the city from becoming capital of two states, an internal EU report found Wednesday, urging members to block funding for any settlement activities.
In its Jerusalem Report 2012, a copy of which was seen by AFP, the European Union said Jewish settlement construction posed "the biggest single threat to the two-state solution".
And it outlined a series of recommendations urging member states to halt or avoid any financial investment or transactions which could directly or indirectly feed into Israel's settlement-building enterprise -- in an effective call for economic sanctions.
Written by the EU heads of mission in Jerusalem and Ramallah, the strongly-worded report described Israel's settlement construction in east Jerusalem as "systematic, deliberate and provocative", accusing the Jewish state of making deliberate political choices that threaten to render the two-state solution impossible.
An Israel spokesman dismissed the report, saying it showed that the Europeans had failed in their diplomatic mission.
"A diplomat's mission is to build bridges and not to encourage confrontation," foreign ministry spokesman Yigal Palmor told AFP. "These consuls have failed in their diplomatic mission."
But the Palestinians hailed the report, with senior official Hanan Ashrawi saying it was a "responsible assessment" of Israeli actions in east Jerusalem.
"It is ringing an alarm concerning the destructive nature of the Israeli policies and its dangerous implications for peace," she said.
"We hope that this report will be adopted by Brussels and implemented individually and collectively in concrete and tangible steps to hold Israel accountable," she said.
Relations between Israel and the EU have been unusually tense in recent months, with Europe voicing anger over a swathe of Israeli plans for more than 5,000 new settler homes in east Jerusalem.
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In the 15-page report, EU diplomats flagged construction on the southern flank of east Jerusalem -- in Har Homa, Gilo and Givat HaMatos -- as being the "most significant and problematic" saying that if it continued unabated, it would likely cut the area off from Bethlehem by the end of the year.
"The construction of these three settlements is part of a political strategy aiming at making it impossible for Jerusalem to become the capital of two states," it warned.
"If the current pace of settlement activity on Jerusalem's southern flank persists, an effective buffer between east Jerusalem and Bethlehem may be in place by the end of 2013, thus making the realisation of a viable two-state solution inordinately more difficult, if not impossible."
The report also highlighted Israel's plans to build 3,426 units in E1 -- a deeply sensitive strip of West Bank land east of Jerusalem, saying if implemented, it would effectively cut the West Bank in half.
It was the decision to build in E1 as a punishment for the Palestinians winning upgraded membership at the United Nations that saw Europe's frustration peak late last year, sparking Israeli fears that the EU could call for economic sanctions.
The 27-member bloc is Israel's largest import and export market and accounts for about a third of the Jewish state's total trade.
The report makes six recommendations on economic issues, suggesting member states "prevent, discourage and raise awareness about problematic implications of financial transactions, including foreign direct investments, from within the EU in support of settlement activities, infrastructure and services."
It also urges member states "ensure that imports of settlement products do not benefit from preferential tariffs" and that all such products are clearly labelled as originating from areas considered illegal under international law.
Israel captured east Jerusalem during the 1967 Six Day War and later annexed it in a move never recognised by the international community.
It considers all of Jerusalem its "eternal, undivided" capital and does not see construction in the eastern sector as settlement building.
But the Palestinians want east Jerusalem for the capital of their promised state, and they -- along with the international community -- consider settlement construction there and in the West Bank as a violation of international law.