The British government has warned that the official authorisation of Israel's first settlement university will create another hurdle in the peace process.

Israel's defence secretary, Ehud Barak, approved the upgrade of a college in the settlement of Ariel, 11 miles inside the West Bank, earlier this week.

In a statement released on Thursday, the British foreign office minister Alistair Burt said the UK was deeply disappointed by the decision.

"Ariel is beyond the Green Line in a settlement that is illegal according to international law. This decision will deepen the presence of the settlements in the Palestinian territories and will create another obstacle to peace," the statement said.

Burt repeated the government's call for Israel to reverse a recent spate of settlement expansion plans, saying it should "take no further steps aimed at expanding or entrenching settlement activity".

A spokesman for the Israeli foreign ministry said it was "disappointing to see that a [UK Foreign Office] minister should adopt the contested Palestinian position hook, line and sinker, thus adding controversy where it is already in excess".

Britain and other European countries have become increasingly vocal in their criticism of Israel's plans to build thousands of new homes in settlements in the West Bank and East Jerusalem. They say such expansion threatens the possibility of a viable Palestinian state.

An internal analysis paper prepared by Israel's foreign ministry has warned that the European Union may press for the establishment of a Palestinian state independent of negotiations in 2013.

According to a report in Haaretz, the paper said: "A growing understanding can be seen in the EU of the ineffectiveness of the current process.

"This understanding is accompanied by repeated calls to find new channels of progress … The emphasis from their perspective is not on actual direct negotiations between Israel and the Palestinians, but rather on the essential need to move ahead quickly to a permanent-status solution, because the EU recognises that without a solution, things could go downhill on the ground."

European diplomats in Jerusalem have warned that 2013 could be the last chance for the creation of a Palestinian state.

Officials at Israel's foreign ministry are concerned about the country's growing isolation internationally, but fear there is a gap between their position and the stance taken by Israel's political leadership.