Amid plastic bags snagged on gorse bushes, rusting hulks of cars in a breakers yard and a few shabby trailers, traces of a biblical landscape are still to be found on a hillside between the ancient cities of Jerusalem and Bethlehem. A couple of donkeys are tethered to a gnarled olive tree; nearby, sheep and goats bleat as they huddle against the chill December air.

But this terrain will soon be covered in concrete after the authorisation last week of the construction of more than 2,600 homes in Givat Hamatos, the first new Israeli settlement to be built since 1997.

It lies between two existing settlements: Gilo, home to 40,000 people, sits atop one hill; to its east, on another hill, stands Har Homa, whose population is around 20,000, with further expansion in the pipeline. Both are largely built on Bethlehem land.

Givat Hamatos will form a strategic link between these twin towns, further impeding access between Bethlehem and the intended capital of Palestine, East Jerusalem, just six miles away.

Israel considers these and other settlements across the Green Line to be legitimate suburbs of Jerusalem, which it claims as the unified, indivisible capital of the Jewish state. Prime minister Binyamin Netanyahu and official bodies have announced a spate of expansion plans in recent weeks.

In the birthplace of Jesus, the impact of Israeli settlements and their growth has been devastating. In a Christmas message, the Palestinian president Mahmoud Abbas said Bethlehem was enduring a "choking reality".

He added: "For the first time in 2,000 years of Christianity in our homeland, the Holy Cities of Bethlehem and Jerusalem have been completely separated by Israeli settlements, racist walls and checkpoints."

Bethlehem is now surrounded by 22 settlements, including Nokdim, where the hardline former Israeli foreign minister Avigdor Lieberman lives, and Neve Daniel, home to public diplomacy minister Yuli Edelstein.

The city is further hemmed in by the vast concrete and steel separation barrier, bypasses connecting settlements with Jerusalem and Tel Aviv, and Israeli military zones. With little room to expand, it is now more densely populated than Gaza, according to one Palestinian official.

In Beit Sahour – the site on the eastern edge of Bethlehem where, according to Christian tradition, angels announced the birth of Jesus to shepherds in a field – William Sahouri is feeling the squeeze. Ten years ago, he moved into a housing project designated for young Christian families, which overlooks fields and hills where sheep once grazed.

Now most of that land is on the other side of the separation barrier, inaccessible to Palestinians. Har Homa – which, like all settlements in East Jerusalem and the West Bank, is illegal under international law – is rapidly spreading down the hill. Cranes are at work on new apartment blocks; bulldozers are flattening land for new roads and buildings.

In contrast, Sahouri's home, along with others in the neighbourhood, is under an Israeli demolition order. It was issued in 2002 soon after the apartments were built without a permit, which is almost impossible to get in areas of the West Bank under full Israeli military control. After protests, the order was frozen but not lifted.

"It's like sitting on a bomb," says Sahouri, who estimates his family's presence in the area stretches back more than 300 years. "We don't know when it will be blown. At any moment they could come with bulldozers and heavy machinery and everything will be gone."

But, he adds, gesturing across to Har Homa, "the Israelis can build 1,000 homes in three months. In 10 years, they build a city, while we have to build stone by stone."

Residents of Beit Sahour – whose 15,000 population is 80% Christian – say settlers have targeted another nearby spot. A former Israeli military base at Ush Ghurab is visited almost weekly by hardliners from settlements deep in the West Bank, who have repainted the abandoned buildings, planted trees and raised Israeli flags. The site is now known as Shdema to the settlers, who hold regular meetings and activities on the hilltop.

Local Palestinians fear that the visitors will begin to sleep at the former base, then expand the site with additional caravans, followed by the provision of services – electricity, water, roads – and eventually permanent homes. This is a familiar pattern of how radical settlements, unauthorised by the Israeli state, take shape.

"This area is being highly targeted," says local Palestinian activist George Rishmawi. "Experience tells us this is how settlements start – with the actions of fanatics."

On the other side of Bethlehem, another mainly Christian community is also facing a battle, this one against the planned route of the separation barrier. Under present proposals it will cut off 58 families, plus a monastery and convent, from their land. The monks and nuns of Cremisan have joined forces with residents to fight a legal battle over the route, which will be decided in the Israeli courts early next year.

"The wall will confiscate nearly all our land," says Samira Qaisieh, whose house on the edge of Beit Jala was built by her husband's family almost a century ago. Its vine-covered terrace looks across the valley to Gilo, the Israeli settlement, built on land she says was owned by her grandfather. "Israel says it is doing all this in the name of security. But really they just want a land without [Palestinian] people."

Qaisieh is thinking of leaving unless the barrier is re-routed. "There is no work here. If we lose our land, what is there to stay for? What is the future for my children?"

About two-thirds of the 400-mile West Bank barrier is complete; 85% of its route runs inside the West Bank, swallowing almost 8.5% of Palestinian land. In 2004, the International Court of Justice ruled it was illegal and that construction must stop.

The wall already snakes around most of Bethlehem, its 8m-high concrete slabs casting a deep shadow, both literally and metaphorically. At the Christmas Tree restaurant, where there are almost no takers for the "Quick Lunches" on offer, business has slowed to a standstill since the wall blocked what was once the main Jerusalem-Bethlehem road. Scores of shops along the closed-off artery have shut down altogether.

A few hundred metres along from the empty restaurant, a long steel-caged corridor leading through multiple turnstiles to a checkpoint is the main exit from the city for Palestinians wishing to go to Jerusalem. The Israel Defence Forces issues thousands of extra permits to Christian Palestinians to allow them to visit holy sites in Jerusalem over Christmas, but the lack of routine access has had a dire impact on businesses and employment rates.

Bethlehem has one of the highest rates of unemployment of all West Bank cities, at 18%, says Vera Baboun, who was elected as its first female mayor in October. "We are a strangulated city, with no room for expansion due to the settlements and the wall."

In a booklet to mark Christmas 2012, Kairos Palestine, a Christian alliance, says: "Land confiscation, as well as the influx of Israeli settlers, suggest that there will be no future for Palestinians (Christian or Muslim) in [this] area. In this sense, the prospect of a clear 'solution' grows darker every day."

Over recent decades Christians have left Bethlehem in their thousands, and now are a minority in a city they once dominated. In 2008 Christians accounted for 28% of Bethlehem city's population of about 25,000. The daily grind of living under occupation, with few opportunities, little hope and the violence of the Palestinian uprising 10 years ago are cited as the chief reasons for departure. But in the past few years the flood of emigrants has slowed. "We are here, and we will remain here, to help our new state become a reality," says Nora Carmi of Kairos.

In Beit Jala, parish priest Father Ibrahim Shomali, who leads open-air prayers under olive trees at sunset every Friday to protest at the planned route of the barrier around the Cremisan monastery, fears its construction could lead to a fresh wave of Christian departures. "People are leaving," he says wearily. "But some of us will stay, to pray and resist."