The interior ministry gave the go-ahead for the units located in the existing settlement of Ramat Shlomo in volatile east Jerusalem, the Peace Now non-governmental organisation told AFP.
"The... decision on the 500 homes in the Ramat Shlomo settlement come after Prime Minister Benjamin Netanyahu's announcement last week that he would accelerate construction in east Jerusalem," Peace Now spokeswoman Hagit Ofran said.
Netanyahu's office pledged on October 27 to build more than 1,000 new settler homes -- more than 600 in Ramat Shlomo and around another 400 in Har Homa, another east Jerusalem settlement.
"Israel is absolutely within its rights to build in Jewish neighbourhoods, and Palestinians have understood that these areas will remain under Israel control under any (peace) agreement," Netanyahu said at the time.
Ofran said the plans had been put on hold since 2006, but with the new approval building itself could begin within six to 12 months.
"The decision to move forward in Ramat Shlomo is irresponsible," Ofran said.
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"It proves that Netanyahu does not want a two-state solution, only a settler state."
Israel, at odds with the international community, views Jewish settlements in annexed east Jerusalem as neighbourhoods where it has the right to build, because it considers the entire city, including the eastern sector, its undivided capital.
Last week's announcement infuriated the Palestinians, who want east Jerusalem as the capital of their future state, and came after Israel's ally the United States warned the Jewish state over its controversial settlements policy.
The State Department has said it is "deeply concerned" over settlement building, and the White House warned last month that continued settlement plans would "distance Israel from even its closest allies".
The European Union has repeatedly slammed Israeli moves to build more settler homes, saying they undermines efforts to achieve peace through a two-state solution.
The settlements issue has derailed round upon round of failed Middle East peace talks, most recently in April after a nine-month concerted push by Washington to bring about a peace agreement.
Israel captured Arab east Jerusalem in 1967 and later annexed it, in a move never recognised by the international community.