An EU document stressing that East Jerusalem should be the capital of a future Palestinian state brought a sharp response today from Israel, which claimed Brussels was damaging the prospects of peace talks restarting.

The draft document, to be discussed by EU foreign ministers next week, strongly criticised Israeli policies towards the Palestinians and warned negotiations need to resume urgently to break the "stalemate" in the peace process. Although the EU has long said that Jerusalem's future should be resolved in final status negotiations, the draft appears to be part of a diplomatic effort to strengthen the Palestinians and encourage them to return to talks.

The draft says a future Palestine should be made up of the West Bank and Gaza with East Jerusalem as its capital. It adds that the EU did not recognise Israel's annexation of East Jerusalem – a position shared by the rest of the international community. "If there is to be a genuine peace, a way must be found to resolve the status of Jerusalem as the capital of two states," says the draft, which the Israeli newspaper Ha'aretz has obtained a copy of.

Sweden, which currently holds the EU presidency, was singled out for blame by Israel. "The move led by Sweden damages the ability of the European Union to take a role and be a significant factor in negotiations between Israel and the Palestinians," the Israeli foreign ministry said.

"After the important steps taken by the government of Israel to enable the resumption of negotiations with the Palestinians, the European Union must now exert pressure on the Palestinians to return to the negotiating table. Steps like those being led by Sweden only contribute to the opposite effect."

Mahmoud Abbas, the Palestinian president, has refused to resume negotiations – now frozen for a year – unless Israel halts all construction in settlements, in line with its US roadmap obligations. Israel has refused, offering instead a 10-month partial freeze but insisting it will continue to build inside East Jerusalem settlements and on 3,000 homes and all public buildings in West Bank settlements.

Abbas has threatened not to run in the next presidential election, apparently out of frustration with a lack of progress and of US support. Diplomats, and most senior Palestinian leaders, want him to stay.

The document – which comes ahead of a meeting on Tuesday of the EU foreign affairs council – insists that the borders of a future Palestinian state must be based on those in 1967, which stood until the six day war, and should only be changed under joint agreement. The draft also talks about recognising Palestinian statehood. This comes at a time when Palestinian leaders have considered a unilateral declaration of independence or attempting to win a UN security council resolution affirming statehood over the West Bank, East Jerusalem and Gaza.

But the wording was careful not to say when such recognition would come. "The council [of the EU] also reiterates its commitment to support further efforts and steps towards Palestinian statehood and to be able, at the appropriate time, to recognise a Palestinian state."

It said settlements, Israel's separation barrier and the demolition of Palestinian houses were "illegal under international law, constitute an obstacle to peace and threaten to make a two-state solution impossible." Israel's long-running economic blockade of Gaza was "unacceptable" under international law and "politically counterproductive."

But there was limited praise for Israel. In the draft the EU says it hopes the 10-month partial settlement freeze "will become a step towards resuming meaningful negotiations" and welcomed Israel's removal of some of its hundreds of checkpoints and obstacles in the West Bank.

Today more Jewish settlers moved into a Palestinian house in Sheikh Jarrah in East Jerusalem, an area that has become a front line in Israel's settlement project. Several Palestinian houses in the east of the city have been demolished in recent weeks. A UN spokesman described these as "provocative actions" and said they should "cease immediately".