If you walk out of Jerusalem Old City through its south-eastern gate and on to the perimeter road encircling it, you will most likely see several large coaches with elderly western tourists climbing out of them. You will see them stand at the low wall at the edge of the road and peer down into the lush valley with its pretty houses that nudge and lean against each other. The tourists may notice the woman marking exercise books on her sunny terrace, they may smile to see the bright-haired four-year-old riding her tricycle round the yard. Some of them will think of a favoured grandchild back in Kansas or Ottawa.

Now, if this were a scene in Italy, Spain, or even Turkey, we might have left it there: the tourists come, stare, spend money and go. But here their effect is devastating – and most of them don't even know it. For the town that nestles here, in this valley on the southern flank of Jerusalem, is Silwan, home to some 55,000 Palestinians, annexed by Israel along with east Jerusalem in 1967, and currently one of the hottest spots in the contest between the rights of the Palestinian townspeople and the plans that Israel has for the area – plans put into effect through a series of administrative measures, clandestine coalitions, and progressive-sounding projects. None of which could work without the funding that floods into Israel from the west.

What do the tourists know of this? These gentle, grey-haired folk have come here, on their Jewish National Fund coaches, to visit the archaeological dig for Ir David, the City of David, which, it is claimed, lies below the Wadi Helweh neighbourhood in Silwan and justifies the digging, the shafts and the tunnelling going on in the belly of the hill and under the homes of the people who live here.

Maryam puts aside the exercise books: "This road, from Jerusalem all the way down the valley, was a main road. People did good business here, if you had an ice-cream shop, a cafe, a barber, food shops, souvenirs. Then Elad came, the City of David Organisation; they take the people into their centre and they never see us."

Silwan, and particularly the beautiful Wadi Helweh – the Valley of Sweet [Water] – has always welcomed strangers. Traditionally, it has been the last resting spot for travellers approaching Jerusalem from the south and a favourite recreation area for Jerusalem's residents. People would come here for picnics, and in summer the cool caves of Ein Silwan spring were a much-loved playing space for children. Even now people ask if I am visiting Silwan for a shammet hawa, a breath of air, though there is hardly air to breathe with the dust and the noise Elad is generating.

Elad is an acronym in Hebrew meaning "To the City of David". Dedicated to "strengthening Israel's current and historic connection to Jerusalem", it was founded in 1986 by David Be'eri, who, "inspired by the longing of the Jewish people to return to Zion", left his elite army unit to set it up. For a long time Elad refused to reveal the names of its funders; eventually they submitted the names but successfully requested they be kept under privilege. Lev Leviev and Roman Abramovich have been present at Elad events.

Elad set up a two-pronged strategy: to strengthen Israel's "connection to Jerusalem" they started to dig – under Silwan and into the land under the al-Aqsa mosque – for the biblical City of David and to create the Ir David tourist site. [See footnote] They called it "salvage excavation" to avoid getting official permits. The "salvage" has lasted for more than 10 years and Wadi Helweh's houses have started to sink into the hill.

To help "the Jewish people to return to Zion", in 1991 Be'eri started to acquire Palestinian property (supported by Ariel Sharon, then minister of construction and housing). His target was principally two Silwan neighbourhoods: Wadi Helweh and al-Bustan (the Garden).

The Abbasi family's home, with its nine apartments and two warehouses, was Be'eri's first target. Be'eri's wife, Michal, has described how he acquired it: "Davida'leh took a tour guide card and put in his picture, and for a long time he would take bogus tourists on a tour . . . and slowly he befriended Abbasi . . . Of course, it was all staged." In 1987, Elad pressured the government to declare the Abbasi house "absentee property" and in October 1991, Be'eri led a settler invasion of the house with the intruders singing and dancing and waving the Israeli flag on the roof at daybreak. The Abbasi family went to court and the Jerusalem district judge found "no factual or legal basis" for the takeover; indeed, he found it characterised by "an extreme lack of good faith". Yet still the property continues to be caught up in legal proceedings and Elad people continue to live in it – and to acquire more Palestinian property: to date Elad has gained control of a quarter of Wadi Helweh.

What is happening in Silwan is not unique; it is part and parcel of what is happening across Israel and the Occupied Palestinian Territories. Only the specific tactics are different. Before I came to Silwan, I had been travelling in the West Bank for a week, noting how every Palestinian community has its appointed settlement, its stalking "other". There is hardly anywhere you can look up and not see a settlement lowering at you: bristling with barbed wire and flags and antennae and cameras and floodlights and – although you can't see them – arms.

Most scholars agree that, to this day, no evidence of the presence of Kings David or Solomon has been found at the site. But our group of elderly American tourists are spellbound by the stories they are hearing from Elad's guides, stories which are conjecture, projection and myth .

"I found a Byzantine water pit," Professor Ronny Reich of the Israel Antiquities Authority says. "They [Elad] said it was Jeremiah's pit. I told them that was nonsense." But for a long time the guides would tell the tourists that this was the hole Jeremiah was thrown into. Close to half a million visitors come here each year and are treated to the Elad version of history. Professor Binyamin Ze'ev Kedar, chair of the Israel Antiquities Authority Council, wrote in 2008: "The Israel Antiquities Authority is aware that Elad, an organisation with a declared ideological agenda, presents the history of the City of David in a biased manner."

None of this activity would have been possible without the support of the Israeli state. An Israeli activist tells me: "If you ask the Israeli government what is happening in Silwan, they say it's not a government matter; these are private people buying and moving in legally. But now [the east Jerusalem settlement of] Nof Zion is being built. The Zoning laws permit building there only on 37.5% of a piece of land. But Nof Zion has permission to build on 125% of the land! And inside Ras el-Amoud, above Silwan, they are building five-storey apartment blocks for settlers. But they refuse to allow Palestinian families to build a third floor on their house. A settler organisation buys a police station from the government. A bus line in Ma'ale Zeitim is diverted to serve a settlement. In Silwan, the City of David Organisation is telling the archaeologists where to dig and what to look for. So one has to ask the question with regard to the City of David Organisation and the state of Israel: which is the tail and which is the dog?"

A critically important study by the independent monitoring organisation, Ir Amim, reaches the same conclusion: "Elad, which is officially a private organisation, serves as a direct executive arm of the government of Israel, and enjoys comprehensive and deep backing by the Israeli administration." More chillingly, Doron Spillman, Elad's director of development, has said: ". . . We are almost a branch of the government of Israel, but without getting buried under government bureaucracy."

The main government project right now is for Jerusalem. And in Silwan and Jerusalem, on 12 May, Jerusalem Day, the day I visit, you can see it clearly. This morning, Silwan is blockaded by the police, and it's on alert. The settler, security, police and army vehicles racing up and down the roads are quietly monitored by the neighbourhood watch people. In the cafe at the bottom of the valley, three young men wipe tables and stock the fridge while keeping an eye on the jumpy young security guard who patrols in front of them.

"These are private security for the settlers. They don't go anywhere without them. They cost around 50m shekels a year. And they're paid for by the government. Out of taxes," says one of the young men.

"And the security are protected by the police, and the army's always round the corner. Just think what it's costing."

On the eve of Jerusalem Day celebrations, prime minister Binyamin Netanyahu said: "Jerusalem is our city and we never compromised on that, not after the destruction of the First Holy Temple, nor after the destruction of the Second . . . There is no other nation that feels this deeply about a city."

Now, in the pleasant afternoon, I stand in the Solidarity Tent in al-Bustan with two men whose homes are among the 88 threatened with demolition to make way for an "archaeological garden in the spirit of the Second Temple".

"So they distribute bits of paper that say that since King David used to go for walks here, it's wrong that our houses should be here and it must just be a park. You notice that for them he is King David but for us he is el-Nabi Daoud: David the Prophet. So who holds him in higher esteem? Plus there's no evidence he ever walked here," says one.

"And what if he did? It was empty. You know, there's one thing we've held against our parents, our grandparents: that they left their land. They thought they'd be back in a couple of weeks. We don't have the excuse of ignorance. We are not leaving. And my children will not wash the dishes in their national park," says his friend.

In Silwan and Jerusalem, the conflation between settler rightwing ideology, government policy, big money, real estate interests and bad taste produces its unique blend of kitsch and nightmare. Under cover of excavation, massive infrastructure work is done in Wadi Helweh in preparation for the construction of a 115,000 sq m commercial centre, without a town plan scheme and without permits. The work stops only when it comes up against the foundations of Palestinian homes.

"The streets cave in," says one of the men. "You see that darker stretch of tarmac? We had to patch up the road. And the school: the floor of the classroom collapsed under the girls. Fourteen girls fell 2m into the tunnel they'd dug below the school. And we had to hush it up because they would have said the school was unsafe and closed it down." The Israeli military barricade continues to block Silwan's high street.

In Jerusalem earlier, I had seen thousands of young people who had been bused in from the settlements stream through the streets. Military police with guns and flack-jackets guard them. The Old City is closed – except to them. Women trying to take their children home are turned away from the gates of the city. Men carrying briefcases sit on raised pavements. More soldiers watch from the ramparts of the old city walls. From time to time the police come up to us: "You speak Hebrew?" No. "You speak English?" Yes. "Back! Move back!" A man standing next to us says maybe they want us to back off all the way to Spain. "Where are you from?" he asks me. Egypt. "Cairo?" Cairo. "May God forgive Cairo," he says.

Darkness settles. The Palestinian residents of Silwan feed their kids and hush them. They visit each other, chat, watch the news. In the cafe at the bottom of the hill the young men are courteous but not chatty. On their TV screen Alan Curbishley talks about the match that's about to start: the final of the Europa Cup. The young men keep one eye on the screen, the other, vigilant, is on their town. On the ledge above their heads, but hidden from their view, is the stage set up by Elad, with its "Lion of Zion" banners. And we can hear the amplified voices celebrating the three Israelis each being awarded the $50,000 "Lion of Zion" Moskowitz award for deeds that "deal with the challenges facing Israel in the fields of education, research, settlement, culture, security and more".

From the al-Aqsa mosque further above comes first the call for evening prayer, and then, for good measure, the Chapter of the Merciful: "Which then of our Lord's signs do you deny?" The lights in the Palestinian houses dot the hillside and the trees around the small cafe where I sit are also strung with fairy lights. In a layby 20m away an Israeli army personnel carrier stands poised, its blue lights flashing.

The Palestinians sense that Israel has moved from ihtilal to ihlal; from occupation to replacement, and that making life unlivable for Palestine's Palestinians is the prelude to transforming Palestine itself. This is what the money coming from the west will achieve. To see the future projected for Jerusalem, you need only visit the spanking new Jewish Quarter. Go into the Temple Shop and buy teatowels and doilies and puzzles featuring the Third Temple rising out of al-Haram al-Sharif in place of the Dome of the Rock. In this approaching future it will be impossible to look out at the landscape and think of continuity, or eternity.

In place of the old, mellow stone, of the interdependent structures, softened and polished by time, there will be the jagged and the new and the fake. In place of trodden paths along the valleys and children playing freely, there will be chairlifts and viewing points and fast food outlets and always, always the iron gates and the security checks and the ticket kiosks and the merchandising. In place of the thousands of stories laid down over the ages above, below and around each other, there will be one story – and it won't, actually, be the Jewish story, because the Jewish story in Jerusalem is indivisible from the Roman, the Byzantine, the Arab, the Muslim, the Christian. It will be a fake. Like the fake inscribed prayers or mezzuzas the settlers carve into the Arab houses when they take them over. Soon, in Jerusalem, if the world does not wake up, there will be one voice: the crash of the cash register.

© Ahdaf Soueif 2010. The writer is the author of Mezzaterra: Fragments from the Common Ground (Bloomsbury, £8.99)

• This footnote was added on 1 October 2010. A version of the following clarification was scheduled for publication in the Guardian of 4 October 2010 regarding the phrase in the article above saying that the tunnelling goes "under Silwan and into the land under the al-Aqsa mosque". There are five archaeological projects in Silwan; of the five, the closest runs about 75m from the southern wall of the Temple Mount, as it is known to Jews and Christians, or al-Haram al-Sharif, as it is known to Muslims, upon which the mosque stands.

