Israeli economic sanctions against the Palestinians, in retaliation for their bid to win world recognition of a state of Palestine, have started to bite: officials said Sunday that they won't be able to pay the next round of public sector salaries that support nearly one-third of Palestinians, and that the damage to a fragile economy is devastating.

Critics say Israel isn't entitled to impound funds it collects on behalf of the Palestinians, some $100 million monthly of customs charges and other taxes which form nearly two-thirds of the local revenue of the West Bank-based government of Palestinian President Mahmoud Abbas.

They also argue that withholding the funds is short-sighted, because it fans anti-Israel resentment and weakens the moderate Abbas, whose security services — funded by these payments — have been lauded by Israel for successfully preventing attacks on its civilians by militants.

Israel says freezing the money is intended as a warning to Abbas, but that the measure could turn permanent if he decides to form a unity government with his long-standing rival, the Islamic militant Hamas movement that has ruled the Gaza Strip since a violent takeover in 2007. Such a unity government was to have been formed ahead of Palestinian elections next May, but some Palestinian officials suggest it's off the table for now.

Israel started suspending the funds last month in response to the Palestinians' success in gaining admission to the United Nations' cultural agency UNESCO, which was part of a larger effort to gain recognition as a state in the world body. Israel says a Palestinian state should be established through negotiations and accuses the Palestinians of acting unilaterally to bypass peace talks.

The suspension comes at a time of a growing cash crisis in Abbas' Palestinian Authority, with foreign donors falling several hundred million dollars short of the nearly $1 billion in support sought this year. The Palestinians had a proposed budget of $3.2 billion for 2011, including $1.7 billion needed to cover the government payroll.

Abbas' prime minister, Salam Fayyad, said Sunday that he won't be able to pay upcoming salaries, which are due in the first week of December. He said the continued suspension of the tax transfers "has both an immediate impact on the lives of all employees and their dependents, some 1 million people ... (and) has a devastating indirect impact throughout the whole economy."

Economics Minister Hassan Abu Libdeh told The Associated Press that the government has already reached its limit of what it can borrow from banks to make the payroll — nearly $1.2 billion so far. He said the cash crunch not only disrupts salary payments, but also government services.

"This is going to have a very dangerous impact because it stops the Palestinian Authority from functioning," Abu Libdeh said. "The international community should be fully aware that this is very counterproductive."

Top diplomats, including U.N. Secretary General Ban Ki-moon and U.S. Secretary of State Hillary Rodham Clinton, have urged Israeli Prime Minister Benjamin Netanyahu to release the funds, so far to no avail. Israeli governments have temporarily suspended the tax transfers in the past, but usually restored them after a few months of international pressure.

The collection of the funds by Israel is part of interim peace agreements of the 1990s. Among the funds collected, for a fee paid by the Palestinians, are customs duties and value-added tax on imports that come through Israeli ports but end up in the Palestinian areas. Israel also turns over to the Palestinian Authority a significant portion of money held from the paychecks of Palestinians working in Israel.

Ron Pundak, a member of an Israeli-Palestinian economic think tank, said suspending the tax transfers amounts to piracy by Israel. "We are not entitled to do it, it's against all agreements," said Pundak, who helped negotiate those interim agreements.

In the long run, withholding the funds could seriously weaken the Palestinian Authority and contribute to its collapse, he said. In such a case, Israel would once again have to assume the costly responsibility for the welfare of nearly 4 million Palestinians.

The Palestinian Authority pays the wages of some 150,000 civil servants and members of the security forces. This includes tens of thousands of beneficiaries in Gaza who were pushed out of their jobs after the Hamas takeover but continue to receive salaries.

An Israeli government official said the suspension was intended to deter Abbas from bypassing peace talks. Netanyahu has offered to resume negotiations, but Abbas insists Israel must first halt all construction in the West Bank and east Jerusalem, areas the Palestinians claim for their state. Israel withdrew from Gaza in 2005.