Britain and other Western states were locked in an escalating diplomatic confrontation with Israel tonight over plans by Benjamin Netanyahu’s government to build thousands of homes in the West Bank and East Jerusalem.

The Israeli envoys to Britain, France, Spain and Sweden were warned that going ahead with the project could jeopardise the peace process and erode Western support for the Jewish state. The UK is also said to be considering cancelling some trade deals and, while reports that the UK and France may withdraw their own ambassadors were played down, officials in London and Paris maintained that the option was on the table.

The settlement plan was presented in Israel as a reaction to Fatah’s successful bid for recognition by the United Nations General Assembly as a “non-member observer state” last week. But the construction of 3,000 homes, particularly in the E1 area, north-east of Jerusalem, would effectively bisect the West Bank and further damage Palestinian aspirations of sharing Jerusalem in a future two-state solution.

There is anger that Israel has ignored the West’s repeated requests not to go ahead with the settlement plans despite being given widespread support during its offensive in Gaza. Furthermore, senior diplomats say, the Israelis were fully aware that the backing for Hamas had risen after its rockets hit Tel Aviv and a district of Jerusalem - at the expense of the Palestinian Authority head Mahmoud Abbas - and going ahead with the construction would further undermine him and the PA. The Israelis were already withholding around £75m needed by the PA to pay civil servants with the Israeli Finance Minister Yuval Steinitz openly stating this was in retaliation for the UN move.

The Foreign Office minister, Alistair Burt, said: “This morning I met the Israeli ambassador to the UK, Daniel Taub, who was formally summoned to the Foreign Office.

“Mr Taub was summoned following the Israeli decisions to build 3,000 new housing units in East Jerusalem and the West Bank, to unfreeze planning in the area known as E1 and to withhold tax revenue from the Palestinian Authority. I set out the depth of the UK’s concern about these decisions and I called on the Israeli government to reverse them. The settlements plan in particular has the potential to alter the situation on the ground on a scale that threatens the viability of a two-state solution.

“I also made clear that the strength of our reaction stems from our disappointment that the Israeli government has not heeded the calls that we and others had made for Israel to avoid reacting to the UN General Assembly resolution in a way that undermines the Palestinian Authority or a return to talks.”

The settlement plan had already been condemned by the US Secretary of State, Hillary Clinton. And the UN Secretary-General Ban Ki-moon has stated the deal would be “an almost fatal blow” to a two-state solution. The EU foreign affairs chief, Catherine Ashton, stressed such expansion “may represent a strategic step undermining the prospects of a contiguous and viable Palestine with Jerusalem as the shared capital of both it and Israel”.

In Paris, France’s Foreign Minister, Laurent Fabius, said Israel’s plans were a “new area of colonisation” and, if confirmed, would “sap the necessary confidence in a resumption of talks”.

Israel, however, remained unrepentant. Mr Steinitz said his government could not have remained indifferent to the Palestinians’ unilateral move at the UN. “I want to tell you that those same Europeans and Americans who are now telling us ‘naughty, naughty’ over our response understand full well that we have to respond, and they themselves warned the Palestinian Authority,” he said.

Yesterday the contentious area, E1, was deserted. There are street lights, electricity cables and water mains, but no houses.

“E1 sits smack in the middle of East Jerusalem, bifurcating the contiguity of land on which the future of a Palestinian state depends, creating two cantons out of the West Bank. This is why E1 is known as the nail in the coffin of the two-state solution,” said Betty Herschman of Ir Amim, a pressure group that advocates co-existence in Jerusalem.