JERUSALEM, July 19 (Reuters) - Legislation that Israel's Arab citizens fear could limit their freedom of speech came a step closer on Sunday to becoming law.

The bill, proposed by a legislator from the ultranationalist Yisrael Beitenu party of Foreign Minister Avigdor Lieberman, would withhold government money from any state-supported institutions that fund activity deemed detrimental to the state.

Such activity includes "rejecting Israel's existence as the state of the Jewish people" and supporting "armed struggle or terrorist acts" against Israel.

A ministerial committee approved the bill, clearing the way for its presentation to parliament for future debate and voting.

The legislation is a watered down version of a proposed law that would have made it a criminal offence to commemorate the "Nakba" on Israel's independence day. The term refers to what Palestinians describe as the catastrophe they suffered when Israel was created in 1948.

About 1.5 million, or 20 percent, of the country's citizens are Arabs of Palestinian origin.

Leaders of the Israeli Arab community have been outspoken in rejecting any definition of Israel as a Jewish state and in supporting their Palestinian brethren's statehood aspirations in the occupied West Bank and Gaza Strip.

Israeli Arab lawmaker Ahmed Tibi described the bill as "Lieberman's thought police running amok and dragging the entire government with it."

Tibi said "hatred of Arabs has caused the government to lose its mind".

Criminal penalties in an earlier draft of the bill were removed at the request of several ministers. (Writing by Ori Lewis; Editing by Jon Boyle)