JERUSALEM, March 7 (Reuters) - Israel accelerated its "illegal annexation" of East Jerusalem last year through municipal and security policies that discriminated against Palestinian residents, an EU report said.

The internal report by European diplomats, dated Dec. 15, 2008, was obtained by Reuters as fresh controversy simmered over Israel's plan to demolish scores of Palestinian homes in East Jerusalem, part of territory seized in the 1967 Middle East war.

The number of building tenders issued by Israel for Jewish homes in East Jerusalem increased by a factor of 40 in 2008 over 2007, the report said, while Israeli authorities placed "severe restrictions" on construction permits for Palestinians, who were also denied municipal funding proportionate to their population.

The report also criticised Israel for constructing a barrier that runs through Jerusalem, saying it cut off thousands of Palestinians from the occupied West Bank. Israel says the barrier keeps out suicide bombers and has vowed to complete the Jerusalem section by 2010.

The 20-page report acknowledged Israel's security needs but said its "actions in and around Jerusalem constitute one of the most acute challenges to Israeli-Palestinian peace-making".

Israel annexed East Jerusalem as its capital, a move not recognised internationally. Palestinians want to found a state in the West Bank and Gaza with its capital in East Jerusalem.

The Jerusalem municipality said last month it planned to demolish 88 Palestinian homes, though not immediately, that were built without permits in another section of Silwan, near the walls of Jerusalem's Old City, to create a public garden.

U.S. President Barack Obama has vowed to revive peacemaking and his secretary of state, Hillary Clinton, who visited the region this week, called the planned demolitions "unhelpful".

Israeli officials deny there is a campaign to drive out Palestinians, who make up 34 percent of Jerusalem's population. (Editing by Dominic Evans)