Britain and the US have warned that Israel's plans to build new housing settlements in the West Bank would damage the prospect of creating a two-state solution to its conflict with the Palestinians.

British foreign secretary, William Hague expressed "extreme concern" at the plan to create 3,000 new homes in the key strategic area of Palestinian territory would seriously undermine the Middle East peace process, and corrode Israel's international reputation.

The Israeli announcement on Friday came a day after the UN recognised Palestine as a non-member observer state. Palestinians say that the proposed development would break the West Bank in two, thereby preventing any hope of a contiguous Palestinian state.

"I am extremely concerned by reports that the Israeli cabinet plans to approve the building of 3,000 new housing units in illegal settlements in the West Bank and East Jerusalem," Hague said. "Israeli settlements are illegal under international law and undermine trust between the parties. If implemented, these plans would alter the situation on the ground on a scale that makes the two-state solution, with Jerusalem as a shared capital, increasingly difficult to achieve.

"They would undermine Israel's international reputation and create doubts about its stated commitment to achieving peace with the Palestinians. The UK strongly advises the Israeli government to reverse this decision. The window for a two-state solution is closing, and we need urgent efforts by the parties and by the international community to achieve a return to negotiations, not actions which will make that harder."

The plans also drew a terse reaction from the US state department. "These actions are counterproductive and make it harder to resume direct negotiations or achieve a two-state solution," said spokeswoman Victoria Nuland.

Britain abstained at the UN general assembly vote over Palestine's status on Thursday, after President Mahmoud Abbas failed to satisfy Hague's demand that he give assurances to resume peace negotiations without preconditions.

The vote on upgrading Palestinians from "permanent observer" to non-member observer state has long been viewed as a milestone in Palestinian ambitions for independent statehood.

Meanwhile, one of six Palestinians who were shot by Israeli troops on Friday, while protesting at the Gaza Strip boundary fence died this morning, according to hospital officials. The 21-year-old man had been demonstrating near the southern town of Rafah.