Word of the new construction in the Beitar Illit settlement and their possible complication of the talks came amid a flurry of activity by the U.S. to try to salvage peacemaking.
Vice President Joseph Biden arrived in Israel on Monday, marking the highest-level visit to Israel and the Palestinian territories by an Obama administration official.
CBS Radio News correspondent Robert Berger reports that Biden is widely expected to urge Israel not to carry out its threat to attack Iran's nuclear facilities. Biden's message will simply be: "Don't bomb Iran," as one Israeli official put it.
Biden will meet separately with Israeli and Palestinian leaders to give a boost to new indirect peace talks, reports Berger.
Washington's special envoy to the Mideast, George Mitchell, was also in the area, meeting Monday with Israeli Prime Minister Benjamin Netanyahu and Palestinian President Mahmoud Abbas.
Palestinian negotiator Saeb Erekat accused Israel of trying to undermine the talks even before they began. "If the Israeli government wants to sabotage Mitchell's efforts by taking such steps, let's talk to Mitchell about maybe not doing this (indirect talks) if the price is so high," Erekat said.
The Palestinians presented the U.S. envoy with a document outlining their desired peace agreement - a Palestinian state in Gaza and the West Bank, with minor border adjustments. At his meeting with Mitchell, Abbas also raised the issue of the new construction, Erekat said, saying it "put a big question mark on what it is that we came to do."
Netanyahu sounded upbeat after his meeting with the U.S. envoy Monday. "I believe we will succeed in advancing the diplomatic process," the Israeli leader said. "But the diplomatic process is not a game, it is real, and rooted first and foremost in (Israel's) security."
Jewish construction in the West Bank and east Jerusalem is a particularly sore point with the Palestinians because it challenges their claims to lands they want for a future state.
Under heavy U.S. pressure, Israel agreed in November to restrict building in the West Bank to some 3,000 apartments whose construction was already under way. But it rejected any curbs in east Jerusalem, which the Palestinians want for their future capital.
The government said at the time that exceptions to the slowdown could be allowed, and on Monday, the Ministry of Defense said an exception was made in the case of the ultra-Orthodox Beitar Illit because of what it termed safety and infrastructure issues. The ministry said it was the biggest exception granted since the slowdown went into effect.
Israeli anti-settlement watchdog Peace Now also questioned Israel's motives. "The Israeli government is welcoming the (U.S.) vice president by demonstrating, to our regret, that it has no genuine intention to advance the peace process," said the group's settlement expert, Hagit Ofran.
On Sunday, Palestinian leaders agreed to take part in U.S.-brokered peace talks with Israel for four months, ending a 14-month breakdown.
In so doing, they backed off from a demand that Israel freeze all building in the West Bank and east Jerusalem before they would return to the negotiating table.
Militant Palestinian groups like Hamas have condemned Abbas' decision to renew talks, and on Monday several factions based in Damascus accused the Palestinian Authority of caving in to pressure from the U.S. and Israel.
Abbas' Palestinian Authority has close ties to the West, enjoying generous funding from the international community. It has undertaken economic reforms in recent years, and on Monday Palestinian Prime Minister Salam Fayyad unveiled a $3.13 billion budget for 2010, about $80 million more than last year. He said that after years of a conflict-driven downturn, government revenues are up, partly due to economic growth projected at 7 percent this year.
Fayyad said he will more than triple spending on development projects to $667 million, in line with donor countries' desire to see more money earmarked for infrastructure, health and education.