Reporting from Washington and Jerusalem
A day after trying to ease tensions, Israeli Prime Minister Benjamin Netanyahu on Monday rejected U.S. demands to end the construction of new housing units in disputed East Jerusalem, leaving the two allies in the middle of an increasingly uncomfortable diplomatic feud.

The United States wants Netanyahu to order a halt to the construction and make a gesture to Palestinians that could help lead to peace negotiations.

But Netanyahu, arguing that construction of housing units on land occupied by Israel since the 1967 Middle East War poses no harm to Palestinians, showed no signs of acquiescing to U.S. demands.

"The building of those Jewish neighborhoods in no way hurts the Arabs of East Jerusalem and did not come at their expense," Netanyahu told parliament, according to news reports.

Netanyahu did not specifically mention the fate of a 1,600-unit project announced last week.

Jerusalem city officials said they had received no instructions to delay the Ramat Shlomo project.

The announcement of the project came as Vice President Joe Biden arrived for a visit, infuriating Washington and inflaming public opinion among Arabs in a step Netanyahu and other Israelis have acknowledged was a blunder.

The Obama administration last year demanded a freeze on Jewish settlements in the West Bank, and Palestinian leaders have made it a condition for participation in peace talks.

U.S. officials have continued to press the Netanyahu government as they seek concessions for a new round of talks that had been scheduled to start soon.

The White House must decide how far it is willing to push Israel, which enjoys strong popularity among Americans. Secretary of State Hillary Rodham Clinton called the announcement "an insult to the United States," and experts predict a period of stormy relations.

Israel's ambassador to the U.S., Michael Oren, said Sunday that the standoff had became a "crisis of historic proportions," according to reports in Israeli newspapers.

Clinton, in a lengthy phone call to Netanyahu on Friday, requested "specific things" Israel should do to redress the situation, said State Department spokesman P.J. Crowley. In response, Netanyahu expressed regret Sunday, a step the White House called "a good start."

The administration didn't immediately react to Netanyahu's latest statement. Crowley said U.S. officials would not judge Israel's reaction until they received a more formal response to Clinton's request.

Analysts said it was unclear how the Obama administration would respond if Israel said no. Last year, the administration appeared to have no contingency plan when Israel defied demands for a total halt to construction in the West Bank and Jerusalem, and the U.S. appeared weak when it backed away from its original position.

But the risks for Netanyahu are also high, since many Israelis consider strong ties with the U.S. essential to the country's security and stability.

In both countries, conservative and liberal supporters of Israel are wrestling with the issue. Israeli conservatives are urging Netanyahu to stand up to the U.S., which they said is using the crisis in an attempt to cripple, or even topple, his government.

In Washington, many influential members of Congress, such as Rep. Howard Berman (D-Beverly Hills), chairman of the House Foreign Affairs Committee, had yet to take a position.

Sen. Dianne Feinsten (D-Calif.) supported the administration's criticism of Israel.

"I believe strongly that Israel can remain a Jewish democratic state with secure borders only if there is a two-state solution, and a lasting peace," she said. "The chronic expansion of settlements is a serious obstacle which must be overcome."

Republican lawmakers, meanwhile, appeared to be gearing up to denounce Obama over the flap.

Washington's many pro-Israel advocacy groups are divided.

The Anti-Defamation League and the American Israel Public Affairs Committee, or AIPAC, criticized the administration.

It "should make a conscious effort to move away from public demands and unilateral deadlines directed at Israel," said AIPAC, which describes itself as the most influential U.S. foreign policy lobby.

But liberal groups, including Americans for Peace Now, praised the administration.