Jerusalem's decision to leak to the media US displeasure with a plan to build a small housing complex in east Jerusalem was designed to clarify to the Americans that construction in the capital should not be lumped together with any limitations Israel may agree to on building in the settlements, senior diplomatic officials told The Jerusalem Post Sunday.

Moskowitz's critics: building in sensitive areas is a strategy to undermine the peace process

According to the officials, Israel was "defining the boundaries" of where Israel would, and would not, agree to limitations on its construction activity.

Prime Minister Binyamin Netanyahu, responding to the reports that Washington had asked Israel not to build 20 apartments in the Sheikh Jarrah neighborhood in east Jerusalem, near Mount Scopus and the National Police headquarters, said, "I would like to reemphasize that united Jerusalem is the capital of the Jewish people and of the State of Israel. Our sovereignty over it cannot be challenged; this means - inter alia - that residents of Jerusalem may purchase apartments in all parts of the city.

"This has been the policy of all Israeli governments and I would like to say that it is indeed being implemented because in recent years hundreds of apartments in Jewish neighborhoods and in the western part of the city have been purchased by - or rented to - Arab residents and we did not interfere," he said.

"This says that there is no ban on Arabs buying apartments in the western part of the city and there is no ban on Jews buying or building apartments in the eastern part of the city."

Netanyahu said Jerusalem was an open, undivided city "that has no separation according to religion or national affiliation. We cannot accept the idea that Jews will not have the right to live and purchase in all parts of Jerusalem."

The prime minister said that just as there would be an international outcry if Jews were prohibited from buying property in New York, London, Paris or Rome, so too Jews should not be prohibited from buying property in Jerusalem.

"This has been the policy of Israeli governments over the years and it is also the policy of our government," he said.

Later in the day, at a meeting of his inner cabinet, Netanyahu reportedly took the US to task for making an issue of the project, asking what President Barack Obama was thinking, and whether he really thought that after Netanyahu built 20,000 homes in Jerusalem during his first term as prime minister (1996-99), including starting the then very controversial project in Har Homa, he would not build 20 more apartments now in the shadow of Mount Scopus.

Israeli diplomatic officials said that new Israeli Ambassador to the US Michael Oren went to the State Department last week for routine talks, during which his American interlocutors raised their concern about plans approved last month by the Jerusalem Municipality for 20 apartments to be built at the site of the historic Shepherd Hotel in east Jerusalem, bought in 1985 by US bingo magnate Irving Moskowitz.

The officials said that Oren was not summoned to the State Department to discuss the issue, nor was it even the main agenda item of the meeting. Rather, the meeting was planned some two weeks in advance and covered a range of issues.

After Oren relayed the contents of the conversation back to Jerusalem, he received a response to the US concern about the housing project - a response that was along the lines of what Netanyahu said at the cabinet meeting - and went back to the State Department on Thursday, where he relayed the message.

According to assessments in Jerusalem, the Palestinians - concerned that Jerusalem and Washington might find a compromise solution on construction in the settlements - are looking for other issues they can raise with the Americans, in the hope that the Obama administration would continue to turn the diplomatic heat up on Israel.

"The Palestinians are riding the wave," one official said, adding that the Palestinians generally raise these matters with the US and British consulates in Jerusalem, with the hope that they will pass the messages on to Washington and London, which will then pressure Jerusalem.

The official said it was not clear what impact this issue would have on the negotiations over US demands for a settlement freeze. While in recent days there have been reports the sides were headed toward a compromise agreement on the matter, one Israeli official said that while there was "good will" on both sides, we are "not there yet."

The official said that until now, Jerusalem had not been included in the areas discussed regarding a construction freeze.

US Mideast envoy George Mitchell, heading the negotiations on this matter for Washington, is expected to arrive next Sunday for another round of talks.

Even as this story was percolating in Israel on Sunday, Secretary of State Hillary Rodham Clinton said in New Delhi that the administration was trying to reach an agreement with Israel on settlements.

"The negotiations are intense. They are ongoing," she said.

Meanwhile, Avi Diskin, head of the Shin Bet (Israel Security Agency), told the cabinet that Israel had identified widespread activity by the Palestinian Authority and Hamas to block land purchases in east Jerusalem by Jews.

In addition, Diskin said that Egyptian cleric Sheikh Youssef al-Qaradawi of the Muslim Brotherhood had allocated some $25 million for the purchase of property and to build Hamas charitable institutions that would expand the group's reach in Jerusalem.

Diskin said that while there has been a drop in terrorist activity both in the Gaza Strip and the West Bank, there was a "steady trickle" of foreigners into Gaza who were affiliated with the global Islamic jihad movement.

Likewise, he said, Hamas continued to develop its armament capabilities inside Gaza, even though the organization was not currently carrying out attacks.