Prime Minister Benjamin Netanyahu said on Wednesday that Israel's decision to accelerate settlement building was a fundamental right, not punishment for the Palestinians joining UNESCO.
But US, European and Arab officials condemned the move as a blow to Middle East peace efforts.
They also sharply criticised Israel's decision to suspend the transfer to the Palestinian Authority of duties it levies on imports to the territories.
"We build in Jerusalem because it is our right and our obligation; not as punishment but as a basic right of our people to build its eternal capital," Netanyahu told members of parliament.
His inner cabinet decided on Tuesday to speed up construction of Jewish settlements in annexed Arab east Jerusalem and elsewhere in the occupied West Bank, a day after the UN Educational, Scientific and Cultural Organisation accepted Palestine as a full member.
Israel claims the whole of Jerusalem as its "eternal, indivisible capital", including the city's eastern sector, which it annexed shortly after capturing it in the Six Day War of 1967 in a move never recognised by the international community.
But the Palestinians demand east Jerusalem as the capital of their promised state.
"Jerusalem will never return to the state it was in on the eve of the Six Day War," Netanyahu told parliament, denying that the settlement plan could be construed as punitive.
But the decision to speed up settlement construction was described by a senior Israeli government official, who spoke to AFP on Tuesday, as "punishment after the vote at UNESCO."
And the decision to speed up the building of the 2,000 settlement homes was accompanied by a plan to "temporarily freeze the transfer of funds to the Palestinian Authority," the official said.
Every month, Israel transfers to the Palestinian Authority tens of millions of dollars in customs duties levied on goods destined for Palestinian markets that transit through Israeli ports.
The money constitutes a large percentage of the Palestinian budget.
Signup to our newsletter and follow us on Facebook and Twitter!
Israel has previously frozen the transfer of funds as a punitive measure in response to diplomatic or political developments viewed as harmful, prompting criticism.
Israel's top ally Washington on Wednesday led international calls for the Jewish state to abandon its decision to speed up settlement building on occupied territory in retaliation for Palestinian admission to the UN cultural organisation.
"We are deeply disappointed by yesterday's announcement about accelerated housing construction in Jerusalem and the West Bank," said White House spokesman Jay Carney.
"As we have said before, unilateral actions work against efforts to resume direction negotiations and they do not advance the goal of a reasonable and necessary agreement between the parties."
UN Secretary General Ban Ki-moon said he was "deeply concerned" by Israel's decision and "worried at the trajectory of developments" between Israel and the Palestinians and called on both to "refrain from provocations," said his spokesman Martin Nesirky.
EU foreign policy chief Catherine Ashton urged Israel to backtrack on the settlement push. "We call on Israel to reverse this decision," she said.
Britain, France, Germany and Russia also individually condemned the moves, with British Foreign Secretary William Hague warning that the cash freeze was likely to backfire on the Jewish state by undermining the Palestinians' ability to keep order.
"(It) is in no-one's interests, least of all Israel's, since it has direct implications for the Palestinian Authority's ability to maintain effective security in the West Bank," he said in a statement.
The Palestinians too roundly condemned the Israeli moves.
"These measures are no more than collective punishment in violation of all international norms, conventions, agreements, and standards, against Palestinians for demonstrating their right to be represented within the UN and other international forums," Prime Minister Salam Fayyad's office said.
"The Israeli decision to speed up settlement construction with the construction of 2,000 new housing units is an Israeli decision to accelerate the destruction of the peace process," presidential spokesman Nabil Abu Rudeina told AFP.
"And the freezing of funds is stealing money from the Palestinian people."