European governments should consider direct intervention in an attempt to curb the systematic measures being undertaken by Israel to increase its control and population in the historically - and legally - Arab eastern sector of Jerusalem, a highly sensitive EU report concludes.

The confidential report, prepared by top diplomats representing the 25 EU governments in the city, warns that the chances of a two-state solution are being eroded by Israel's "deliberate policy" - in breach of international of law - of "completing the annexation of East Jerusalem".

European Foreign Ministers this week vetoed planned publication of the report - which also warns that rapid expansion of Jewish settlements in and around East Jerusalem, along with use of the separation barrier to isolate East Jerusalem from the West Bank, "risk radicalising the hitherto relatively quiescent Palestinian population of East Jerusalem".

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The report provides the most detailed and remorselessly critical account yet produced by a Western international body of Israel's policy in East Jerusalem, which has been occupied since its seizure in the 1967 Six Day War. It points out that Jerusalem "is already one of the trickiest issues" on the road to a final peace deal between Israel and the Palestinians. It adds that, as a result of the measures, "prospects for a two state solution with East Jerusalem as the capital of Palestine are receding".

Among the recommendations in the report, drafted in October during the British EU presidency which ends next month, the EU is urged to consider a series of steps including direct support for projects that help Palestinians to conduct legal battles against house demolitions, which it points out tripled in the city during 2004, and the persistent refusal to grant building permits to all but a small minority of Palestinians. The report also suggests holding meetings with the Palestinian leadership in East Jerusalem, presumably to demonstrate that - contrary to the Israeli government's goal of Jerusalem as its "undivided capital" - it sees East Jerusalem as the future capital of a Palestinian state.

The EU foreign ministers' meeting was widely reported in Israel to have decided against publication of the report in its present form because of the risk to its relationship with the Jewish state especially when for the first time Israel has given its blessing to the EU having a key security role in the region by monitoring the Rafah crossing point from Gaza into Egypt. The EU will be represented at senior level at a ceremonial opening of the crossing by the Palestinian President Mahmoud Abbas today.

The 11-page report, leaked to The Independent, says the E1 project for a major expansion of Ma'ale Adumim, the largest Israeli West Bank settlement, to join it to Jerusalem "threatens to complete the encircling of the city by Jewish settlements, dividing the West Bank into two separate geographical areas." It says that, while the present 30,000 residents of the settlement at present occupy only 15 per cent of the planned area, the total plan envisages an area of 53 square miles - "larger than Tel Aviv" - extending through the West Bank between Jerusalem and Jericho.

While the plans will divide the West Bank from itself and from East Jerusalem, the report says "the economic prospects of the West Bank [which has a GDP per year per head of $1,000] are highly dependent on access to East Jerusalem [GDP of $3,500]. It adds: "From an economic perspective, the viability of a Palestinian state depends to a great extent on the preservation of organic links between East Jerusalem, Ramallah and Bethlehem".

The document says when the separation barrier is completed, Israel will "control all access to and from East Jerusalem, cutting off its Palestinian satellite cities of Bethlehem and Ramallah, and the rest of the West Bank beyond. This will have serious economic, social and humanitarian consequences for the Palestinians. By vigorously applying policies on residency and ID status, Israel will be able finally to complete the isolation of East Jerusalem - the political commercial and infrastructural centre of Palestinian life."

It adds: "Israel's activities in Jerusalem are in violation of both its Roadmap obligations and international law. We and others in the international community have made our concerns clear on numerous occasions with varying effect. Palestinians are, without exception, deeply alarmed about East Jerusalem. They fear that Israel will 'get away with it' under cover of disengagement [from Gaza]." The document says smaller Jewish settlements inside Palestinian areas are sometimes installed by would-be settlers "preying on Palestinians suffering financial hardship or simply [occupying] properties by force".

Besides suggesting that a formal call by the EU and the US-led international quarter on Israel to stop prejudicing final status negotiations by its actions in East Jerusalem would be "timely", one proposal is for the EU to consider "excluding East Jerusalem from certain EU/Israel joint co-operation activities." While the document does not say so, this could realistically mean halting European funding for road, rail and projects which contribute to the process of annexation.

The reports says the purpose of keeping West Bank ID holders out of East Jerusalem and East Jerusalem ID holders out of the West Bank "is almost certainly demographic , to reduce the Palestinian population of Jerusalem while exerting efforts to boost the number of Israelis living in the city - East and West."