Israel's domestic intelligence agency is urging the government to stop funding a religious college in a Jewish West Bank settlement after warning that its senior rabbis are encouraging students to attack Palestinians.

The intelligence agency, Shin Bet, pressed a month ago for an immediate block on the annual £226,000 grant for the religious college, or yeshiva, in the notoriously extreme settlement of Yitzhar, near Nablus. The Education Ministry has reportedly yet to take a decision despite two meetings with Shin Bet.

Residents of the nearby Palestinian village of Asira El Qbilya say the masked, club-wielding teenage settlers who invaded it last week came from Yitzhar.

The Israeli military disclosed last month that it had issued restraining orders on 12 settlers from the Yitzhar area for "violent and clandestine activity" targeting Palestinians in the West Bank, including endangering lives by "igniting... mosques, vehicles and buildings".

The head of the Od Yosef Hai yeshiva complex in the settlement, Rabbi Yitzhak Shapira, has been filmed accompanying students who threw stones at a Palestinian village. Rabbi Shapira is the author of The King's Torah, a book which suggests that Jewish law on occasion permits the killing of non-Jews.

There was heightened tension in parts of the West Bank last week as Palestinian President, Mahmoud Abbas, submitted his application for UN recognition. A Palestinian was shot dead in Qusra, also near Nablus, by Israeli troops after confronting villagers who gathered in response to a settler invasion. A Jewish settler and his one-year-old son were killed in a car crash near Hebron, which the police say was probably caused by Palestinians throwing stones.

Meanwhile, the US joined Palestinian leaders in condemning Israeli government approval yesterday for the construction of 1,100 new homes in the Jerusalem area settlement of Gilo. It came only days after the international quartet of the US, EU, Russia and the UN urged the parties to "refrain from provocative actions" that might jeopardise future negotiations.

A US State Department official said Washington saw the "continued expansion of settlements" as "corrosive not only to peace efforts and a two-state solution, but to Israel's future itself".