Britain has acted to increase pressure on Israel over its West Bank settlements by advising UK supermarkets on how to distinguish between foods from the settlements and Palestinian-manufactured goods.

The government's move falls short of a legal requirement but is bound to increase the prospects of a consumer boycott of products from those territories. Israeli officials and settler leaders were tonight highly critical of the decision.

Until now, food has been simply labelled "Produce of the West Bank", but the new, voluntary guidance issued by the Department for the Environment, Food and Rural Affairs (Defra), says labels could give more precise information, like "Israeli settlement produce" or "Palestinian produce".

Nearly 500,000 Jewish settlers live in East Jerusalem and the West Bank, which were conquered in the 1967 war. The British government and the EU have repeatedly said Israel's settlement project is an "obstacle to peace" in the Middle East.

EU law already requires a distinction to be made between goods originating in Israel and those from the occupied territories, though pro-Palestinian campaigners say this is not always observed.

Separately, Defra said that traders would be committing an offence if they did declare produce from the occupied territories as "Produce of Israel".

Foods grown in Israeli settlements include herbs sold in supermarkets, such as Waitrose, which chop, package and label them as "West Bank" produce, making no distinction between Israelis and Palestinians. A total of 27 Israeli firms operating in settlements and exporting to the UK have been identified: their produce includes fruit, vegetables, cosmetics, pharmaceuticals, plastic and metal items and textiles.

Other retailers selling their products include Tesco, Sainsbury's, Somerfield, John Lewis and B&Q.

Goods from inside Israel's 1967 borders are entitled to a preferential rate of import duty under an agreement with the EU. Palestinian goods from the West Bank, Gaza and East Jerusalem also enjoy duty-free or reduced-tariff treatment. Settlement products fall outside these two categories.

"This is emphatically not about calling for a boycott of Israel," a Foreign Office spokesman said. "We believe that would do nothing to advance the peace process. We oppose any such boycott of Israel. We believe consumers should be able to choose for themselves what produce they buy. We have been very clear both in public and in private that settlements are illegal and an obstacle to peace."

The TUC general secretary, Brendan Barber, welcomed the public clarification that marking produce from illegal settlements on occupied territory as "produce of Israel" was illegal, but said the government should have gone further.

Barbara Stocking, Oxfam's chief executive, said: "We support the right of consumers to know the origin of the products they purchase. Trade with Israeli settlements – which are illegal under international law – contributes to their economic viability and serves to legitimise them. It is also clear from our development work in West Bank communities that settlements have led to the denial of rights and create poverty for many Palestinians."

Dani Dayan, the Argentinian-born leader of the Yesha Council, which represents Israeli settlers, said the decision was the "latest hostile step" from Britain. "Products from our communities in Judea and Samaria should be treated as any other Israeli product," he said, using an Israeli term for the West Bank.

Israeli officials said they feared this was a slide towards a broader boycott of Israeli goods. Yigal Palmor, Israel's foreign ministry spokesman, said his country's produce was being unfairly singled out.

"It looks like it is catering to the demands of those whose ultimate goal is the boycott of Israeli products," he said. "The message here will very likely be used by pro-boycott campaigners. It is a matter of concern."

He said the issue of different European customs tariffs should not extend to different labelling on supermarket shelves. "It is a totally different thing and not required by the EU."

Israel came under intense US pressure early this year to halt construction in settlements, but has only adopted a temporary, partial freeze. Palestinian leaders say they will not restart peace negotiations until there is a full settlement freeze in line with the US road map of 2003.

The Palestine Solidarity Campaign said it welcomed the new guidance but urged Defra to go further: "The government must seek prosecutions of companies which smuggle settlement goods in under false labels.

"We have received many calls from people who were distressed when they bought goods labelled 'Produce of the West Bank' because they thought they were aiding the Palestinian economy, then realised they were economically aiding Israel's illegal occupation.

"Particularly following Israel's massacre in Gaza, consumers have been shocked at Israel's war crimes and want to take action. They do not want to feel complicit in Israel's occupation by buying stolen goods."

'Customers will now have honest information'

The most recent government figures suggest only about £800,000 of food products, about three-quarters of it olive oil (below right), was imported from occupied Palestinian territories in the three years between 2006 and 2008.

Sainsbury's, which sells dates and small amounts of basil and tarragon, welcomed "the greater clarity on how to label produce from occupied territories".

"This allows us to fulfil our commitment of providing customers with clear and honest information about the origins of their food," the supermarket chain said."We have full traceability back to settlement and/or grower."

Waitrose also said it would be following the guidance on the small number of West Bank lines it sold. "We source a small selection of herbs from the West Bank area, grown on two Israeli-managed farms, on which a Palestinian and Israeli workforce have worked side by side for many years," said a spokesman.

"We are not motivated by politics. Instead our policy is to ensure high standards of farming and worker welfare on the farms from which we source. Our buyers … have visited the two farms in the West Bank to ensure that worker welfare meets the high standards that we insist on. As part of our normal sourcing policy we will be carrying out an audit on these farms in the next six months."

This year the Co-op began selling Fairtrade olive oil from the West Bank – a move hailed by Gordon Brown, who said it meant British shoppers could help Palestinian farmers make a living.

Toby Quantrill, head of public policy for the Fairtrade Foundation, said farmers in Palestine faced barriers to trade which jeopardised opportunities to trade internationally on equal terms with people making similar products. James Meikle

This article originally contained comments wrongly attributed to Barbara Stocking, Oxfam's chief executive. This has been corrected.