Israeli bulldozers demolished part of a landmark building in a predominantly Arab neighborhood of East Jerusalem on Sunday to make way for a Jewish housing project, prompting condemnation from Palestinian officials and symbolic claims to the site from both sides.

Plans for development at the landmark, the Shepherd Hotel, have been in the works since the 1980s. But Jerusalem officials did not give the final go-ahead for the project until March, at the height of tensions between Israel and the Obama administration over construction in contested East Jerusalem.

Palestinians consider the Shepherd Hotel to be part of their heritage. The building has an infamous past: it was built in the 1930s as a villa for Haj Amin al-Husseini, then the grand mufti of Jerusalem, who notoriously aligned himself with Hitler.

“This is a happy day,” said Daniel Luria, a spokesman for Ateret Cohanim, a group that helps Jews move into predominantly Arab neighborhoods of Jerusalem and opposes any division or shared control of the city.

“There is a beautiful poetic justice when you see the house of Haj Amin al-Husseini crumbling down,” said Mr. Luria, who stood outside the gates as bulldozers tore at a newer wing of the building. City officials have said that the original structure will be preserved.

Saeb Erekat, the chief Palestinian negotiator, said in a statement that the demolition “is part of the political program of the Israeli government to pre-empt any solution on Jerusalem.”

He added: “Israel continues to change the landscape of Jerusalem, aiming to change its status and turn it into an exclusive Jewish city.”

The initial plans, to build 20 residential units at the site, have long been a subject of international concern. Secretary of State Hillary Rodham Clinton issued a statement calling the demolition a “disturbing development” that “undermines peace efforts.”

“In particular, this move contradicts the logic of a reasonable and necessary agreement between the parties on the status of Jerusalem,” she said.

Secretary General Ban Ki-moon of the United Nations said that “inserting settlers into Palestinian neighborhoods in Jerusalem” undermined prospects for addressing the city’s status.

Israel annexed the eastern part of Jerusalem after capturing it from Jordan in the 1967 war and says it has sovereignty there. The Palestinians claim East Jerusalem as the capital of a future independent state.

The Shepherd Hotel is in the Sheik Jarrah neighborhood just north of the Old City, in an area that is coveted by both Arabs and Israelis. Although it is mostly populated by Palestinians, nationalist Jewish Israelis have moved into a number of houses there in recent years, evicting the Palestinian residents after Israeli courts ruled that the properties had belonged to Jews before the establishment of the state of Israel and the Jordanian takeover of East Jerusalem in 1948.

Mr. Luria, rejecting Palestinian arguments about the “Judaization” of Arab neighborhoods around the Old City, said he had no problem with Jews and Arabs living together in Sheik Jarrah. He noted that the area was close to the Israeli national police headquarters and several Israeli landmarks.

Members of the grand mufti’s family, the Husseinis, who remain prominent in Jerusalem, milled outside the compound. Among them was Adnan Husseini, the Palestinian Authority’s governor of Jerusalem.

“Everyone in Palestine is sad to see this,” he said.

A scuffle broke out when Palestinians approached Mr. Luria and asked to see a pamphlet he was holding on the grand mufti’s Nazi ties.

After the grand mufti was exiled by the British in 1937, the property became a British military outpost; it was rented to hoteliers during the Jordanians’ rule. The Israeli authorities confiscated the property in 1967, defining its owners as “absentees.” It was purchased by a corporation owned by the businessman Irving Moskovitz of Miami in 1985. In recent years, the hotel had fallen into disrepair.