Israel yesterday reacted angrily to a draft EU proposal for East Jerusalem to be a future Palestinian capital that allows the possibility of endorsing a unilaterally declared Palestinian state.

A draft policy document by the Swedish EU presidency, if approved next week by European foreign ministers, would significantly harden the EU's support for the likely Palestinian stance in any on-going negotiations on a two-state solution.

A statement by Israel's foreign ministry accused Sweden of leading a process which it claimed "harms the European Union's ability to take part as a significant mediator in the political process between Israel and the Palestinians".

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The Israeli statement said that "important steps" had been taken by Israel to enable talks to resume, and the EU should now exert pressure on the Palestinians to return to the negotiating table. Steps like those being taken by Sweden, it said, "only contribute to the opposite effect".

In fact, the Swedish EU move is thought to be designed to encourage Mahmoud Abbas, the Palestinian Authority President, to enter negotiations with Israel by providing him with additional guarantees that the international community envisages broadly the same outcome as he does.

The Israeli Prime Minister Benjamin Netanyahu's declaration of a partial 10-month settlement freeze has triggered anger on the pro-settler right, but the moderate Palestinian leadership is concerned that it will allow 2,500 housing units to go ahead in West Bank settlements and does not cover East Jerusalem. Mr Netanyahu has frequently declared that he will not accept the division of Jerusalem.

European discontent over Israeli settlements will be further demonstrated today when the UK's Department for the Environment, Food and Rural Affairs is expected to announce a new labelling regime for goods from Israeli producers in the West Bank. Labels will need to identify the goods as coming from the settlements, rather than using generic terms like "the West Bank".

EU members have long envisaged Arab East Jerusalem as the capital and have never recognised Israel's claim of sovereignty over it. However, the Swedish draft would commit the EU for the first time to the inclusion of East Jerusalem as the capital of a "viable and contiguous" Palestinian state. The draft also urges Israel to allow the reopening of Palestinian Authority institutions in East Jerusalem.

The Swedish document, leaked to the Israeli daily Haaretz, goes out of its way to praise the Palestinian Prime Minister Salam Fayyad's two-year plan for the preparation of a Palestinian state, and commits the EU "at an appropriate time to recognise a Palestinian state". Publicly, Mr Fayyad has only said he favours an eventual UN call for a Palestinian state based on 1967 borders. But some officials have suggested that this could then form the basis for a unilateral declaration of a state – on the model of Israel's declaration of independence in 1948.

Some diplomats, meanwhile, said they expected the reference to recognising a Palestinian state to be dropped from any final EU communiqué.