Israel has frozen co-operation with the European Union on work in the Palestinian territories in retaliation for an EU directive banning funding or grants for bodies with links to Israeli settlements.

The move, authorised by the defence minister, Moshe Ya'alon, affects all projects requiring permits from the Civil Administration, which governs Area C, the 60% of the West Bank under full Israeli control; access of EU diplomats and representatives to Area C and Gaza; and joint meetings.

No permits have been issued to EU humanitarian aid workers to enter Gaza for several days, according to a western diplomatic source.

"We are freezing the relationship on everything," said an Israeli official. "We did this as soon as we heard [about the directive]. We can't act like nothing happened."

The EU provides aid and equipment to Palestinian communities in Area C, many of whom are threatened with displacement and the demolition of their homes, animal shelters and other structures. The EU also helps train Palestinian security forces.

The directive, published in Brussels last Friday, bans the award of grants, funding or prizes to Israeli institutions located in or with links to settlements across the pre-1967 line. It was met with a furious reaction in Israel, with some claiming it could derail moves towards resuming peace negotiations.

The EU is also considering guidelines for its member states on the labelling of goods and produce which hail from settlements in order to allow consumers to make informed choices on purchases.

The EU was "concerned by reports that the Israeli ministry of defence has announced a number of restrictions affecting EU activities supporting the Palestinian people", said an EU source in Israel. "We have not received any official communication from the Israeli authorities. Our delegations on the spot are seeking urgent clarifications."

The EU and the Civil Administration are thought to have had constructive dialogue over projects in Area C, despite the demolition and threatened demolition by the Israeli military of a number of structures, such as solar panels, funded by European NGOs.

In April, the EU missions in Ramallah and Jerusalem issued a statement criticising the destruction of 22 structures in eight locations in Area C.