Israeli media reported earlier that the government had rejected a request from Washington to freeze the construction work at Gilo.

US President Barack Obama's Middle East envoy, George Mitchell, is said to have made the request to Prime Minister Benjamin Netanyahu at a meeting in London on Monday.

Mr Netanyahu replied that the project did not require government approval and that Gilo was "an integral part of Jerusalem", according to Israel Army Radio.

His spokesman, Mark Regev, declined to comment on the reports, but repeated Israel's refusal to include areas annexed to Jerusalem as part of any accommodation of Mr Obama's call for "restraint" in settlement construction.

"Prime Minister Netanyahu... is willing to adopt the policy of the greatest possible restraint concerning growth in the West Bank, but this applies to the West Bank," he told the Reuters news agency. "Jerusalem is Israel's capital and will remain as such."

The US has pressed for a resumption of peace talks, which were suspended last year, but the Palestinian Authority has demanded that all settlement construction is halted before it will again attend.

'Not ready for peace'

The BBC's Tim Franks in Jerusalem says Tuesday's announcement represents by far the largest batch of planning approvals for building on occupied territory since Mr Netanyahu became prime minister.

The 900 housing units, which will be built in the form of 4-5 bedroom apartments, will account for a significant expansion of Gilo. The interior ministry said construction work would be unlikely to start for another three or four years once the plans gained final authorisation.

A spokesman for Palestinian Authority President Mahmoud Abbas said the planning approval was "yet another step that shows and proves Israel is not ready for peace".

"This step will ruin every single attempt - European or American - to preserve the peace process," Nabil Abu Rudeineh said.

Israel's Peace Now movement, which opposes Jewish settlement activity, said Mr Netanyahu was "showing again that he is spoiling any chance to start negotiations by continuing to create new provocations in Jerusalem".

"This development is intended to torpedo progress that is taking place between US and Palestinians and Israelis on renewing the talks," said Peace Now's Hagit Ofran.

The UK Foreign Office also said it opposed the decision on Gilo.

"A credible [peace] deal involves Jerusalem as a shared capital. Expanding settlements on occupied land in East Jerusalem makes that deal much harder," a statement said.

Nearly 500,000 Jews live in more than 100 settlements built on occupied territory in the West Bank and East Jerusalem.