Construction there would place a major obstacle for Palestinian statehood by cutting off east Jerusalem from the West Bank and plans there had previously blocked by the Bush administration for that reason.
Palestinian negotiator Saeb Erekat condemned the Israeli announcement, saying Israel was "defying the whole international community and insisting on destroying the two-state solution."
He said the Palestinian leadership was studying its options.
Danny Seidemann, a lawyer for Ir Amim, an Israeli group that supports coexistence in Jerusalem, said construction did not appear imminent and there was "quite a lot of drama" in the Israeli announcement.
"There an element of sticking it to the Palestinians," he said, before adding that plans in E-1 were not only a blow to the Palestinians but to the Americans who oppose them too. "E-1 is the judgment day weapons."
Yesh Din, an Israeli rights group, called the Israeli decision "collective punishment" and called on Israel to retract its move.
"Israel should have understood by now that such behavior ... will no longer be tolerated by the international community," said Yesh Din's Executive Director Haim Erlich.
Earlier this month, Israel said it was pushing forward construction of 1,200 new homes in Jewish settlements, in an apparent warning to the Palestinians to rethink their U.N. plan. Israel fears the Palestinians will use their upgraded status to confront Israel in international bodies and extort it to make concessions.
In recent days, though, Israel had appeared to step back from its initial threats of harsh retaliation.
Former Foreign Minister Tzipi Livni, the onetime chief negotiator with the Palestinians, also slammed the decision.
"The decision at the U.N. on a Palestinian state is bad for Israel and so is Netanyahu's response," said Livni, who this week launched a new opposition party. "The decision to build thousands of housing units as punishment to the Palestinians only punishes Israel ... the unnecessary statement only isolates Israel further."