Israeli officials said the country's ambassador to Washington, Michael Oren, was summoned to the State Department over the weekend and told that a project being developed by an American millionaire in the disputed section of the holy city should not go ahead.
Settlements built on captured lands claimed by the Palestinians have emerged as a major sticking point in relations between Israel and the Obama administration because of their potential to disrupt Mideast peacemaking.
Although Prime Minister Benjamin Netanyahu recently yielded to heavy U.S. pressure to endorse the establishment of a Palestinian state, he has resisted American demands for an immediate freeze on settlement expansion.
On Sunday, Netanyahu told his Cabinet there would be no limits on Jewish construction anywhere in "unified Jerusalem."
"We cannot accept the fact that Jews wouldn't be entitled to live and buy anywhere in Jerusalem," Netanyahu declared, calling Israeli sovereignty over the entire city "indisputable."
The international community considers Jewish neighborhoods in east Jerusalem to be settlements and an obstacle to Israeli-Palestinian peacemaking. Israel does not regard them as settlements because it annexed east Jerusalem in 1967 after capturing it in June of that year.
East Jerusalem is an especially volatile issue because it is the site of key Jewish, Christian and Muslim holy sites. The Palestinians want the traditionally Arab sector of the city to be the capital of their future state.
"If the Israeli prime minister continues with settlement activities, he will undermine the efforts to revive the peace process," Palestinian negotiator Saeb Erekat said.
According to Army Radio, the U.S. has demanded that planning approval for the project be revoked.
The approval, granted by the Jerusalem municipality earlier this month, allows for the construction of 20 apartments plus a three-level underground parking lot.
A spokesman for the U.S. Embassy had no immediate comment.
The Palestinians have been encouraged by Washington's insistence that Israel freeze all settlement construction on captured lands in east Jerusalem and the West Bank. Nearly 300,000 Israelis live in West Bank settlements, in addition to about 180,000 Israelis living in Jewish neighborhoods in east Jerusalem.
The Palestinians say the Israeli presence makes it increasingly difficult to establish an independent state in these areas. They have refused to restart peace talks until Israel halts all settlement expansion, something the Israeli government has refused to do.
The east Jerusalem project is being developed by Irving Moskowitz, an influential supporter of Israeli settlement in east Jerusalem who purchased the Shepherd Hotel in 1985 and plans to tear it down and build apartments in its place.
The Jerusalem municipality issued a statement saying the purchase was legal and it had acted with "full transparency" in granting building permits.
The hotel is located near a government compound that includes several government ministries and the national police headquarters.
By Associated Press Writer Amy Teibel