In a confidential report obtained by AFP on Thursday, the European Union accused Israel of actively pursuing the annexation of Arab East Jerusalem and undermining hopes for peace with Palestinians.

The annual report drafted by the EU heads of missions in Jerusalem accused Israel of implementing in 2009 an intricate policy which includes expanding Jewish settlements and demolishing Palestinian homes in East Jerusalem.

"Developments in East Jerusalem in 2009 were marked by the continued expansion of Israeli settlements and a considerable number of Palestinian house demolitions and eviction orders," said the report, published first by Israel's liberal Haaretz daily.

Israel occupied and annexed East Jerusalem in 1967 and considers it its "eternal indivisible capital" in a move never recognised by the international community.

"Israel is, by practical means, actively pursuing its illegal annexation of East Jerusalem by weakening the Palestinian community in the city, impeding Palestinian urban developments and ultimately separating East Jerusalem from the rest of the West Bank.”

The future of East Jerusalem, which the Palestinians want to make the capital of their promised state, is one of the most sensitive issues in Middle East peace talks, which have been suspended for almost a year.

The EU report said that Israel's policies in East Jerusalem "are undermining prospects for a Palestinian capital in East Jerusalem and incrementally render a sustainable two-state solution unfeasible”.

The 14-page report dated November 23 said that Israel's policy in East Jerusalem is "an integral part of a broader Israeli strategy”.

It goes on to accuse the Israeli government and Jerusalem municipality of supporting and assisting private right-wing Jewish organisations in strengthening the Jewish hold in and around the Old City.

"The continued settlement expansion plans around the Old City effectively encircles and contains the historic basin and separates the Muslim holy places from the rest of East Jerusalem," the report said.

It said the municipality places severe restrictions on issuing building permits for Palestinian houses in East Jerusalem, forcing them to construct without permits.

As a result, over 600 Palestinian-owned structures have been demolished since the year 2000, it said.

Last week, Israeli Prime Minister Benjamin Netanyahu announced a freeze on new permits for house construction in Jewish settlements in the rest of the West Bank, but the decision does not affect East Jerusalem, where some 200,000 Jews live in 12 settlements.

Foreign ministry spokesman Yigal Palmor branded the report as "dishonest”.

"This report is based exclusively on Palestinian versions and figures. It reflects the Palestinian propaganda," he told AFP.

Settlers

Netanyahu met settler leaders on Thursday but failed to ease anger over his Cabinet's decision to temporarily cut back on new Jewish construction in the West Bank.

Following the tense meeting in Netanyahu's Tel Aviv office, the settler leaders vowed to continue to oppose last week's decision to impose a 10-month moratorium on issuing building permits for new Jewish homes in the West Bank, outside annexed Arab East Jerusalem.

"Nothing came out of the meeting," settler leader Pinhas Walerstein told AFP afterwards.

According to a government statement, Netanyahu said "there is no going back on the decision", but reiterated construction would resume once the moratorium expires, urging settlers' "patience" in order to avoid a crisis.

"Bibi promised us that at the end of the 10 months, construction will resume, but I seriously doubt it," Walerstein said, using Netanyahu's nickname.

During the meeting, the settler leaders presented numerous complaints on the implementation of the decision, which the prime minister said he would look into and raise with Defence Minister Ehud Barak, the statement said.

"The decision is not easy for you as it is not easy for me, but it is the optimal action for Israel to take under the current conditions and in the challenges facing Israel," Netanyahu was quoted as saying.

Netanyahu said the move was aimed at assisting so-far frustrated US efforts to kickstart the Middle East peace process, which has been on ice for almost a year.