JERUSALEM—Israel on Tuesday outlawed an Islamist group accused of inciting violence among Arab citizens amid a two-month wave of unrest, and approved the construction of hundreds of homes in east Jerusalem.

The government announced that Prime Minister Benjamin Netanyahu’s security cabinet had approved the banning of the northern branch of the Islamic Movement in Israel, a group which provides religious and educational services for Israeli Arabs and has been accused by Israel of waging “a campaign of lies and incitement” against...