Israel approved Sunday listing some Jewish settlements in the occupied West Bank as zones that entitle the communities to millions of dollars of extra state funding.
The cabinet decision was seen as a gesture toward settlers furious about a 10-month moratorium on new building permits in settlements after months of US pressure.
But it is likely to stir furore amid the Palestinians and the international community, which considers all Israeli settlements as illegal.
The cabinet voted to approve a proposal to include settlements in the list of communities designated as "national priority zones," giving them access to credits worth 41 million dollars (28 million euros), a government official told AFP.
It had been expected to approve the proposal during its morning session, but put off the vote amid disagreements over which communities inside Israel should be included on the list.
In its vote, the cabinet also decided to create a commission that will decide within 30 days on whether to include other communities inside Israel, the official said.
The new credits will benefit 110,000 settlers and can be used for vocational training programmes and other educational or cultural activities.
The main settler organisation, Yesha, welcomed the move, but said more steps were needed.
"It is a step in the right direction, but the route remains long," said spokesman Yishai Hollender.
The communities affected on Sunday are mainly outside the large settlement blocs Israel wants to annex under any peace accord with the Palestinians.
Earlier in the day, Finance Minister Yuval Steinitz of Prime Minister Benjamin Netanyahu's Likud party said the move was aimed at expressing support for settlements amid the moratorium.
"With this, we want to send a message (to the settlers) that we understand their difficulties and want to support them," Steinitz told public radio.
The European Union on Friday expressed concern about the plan and said it would consult its partners in the Middle East Quartet over the move.
"Coordination with the Quartet I think is called for in view of the serious nature of such a move," Swedish Foreign Minister Carl Bildt, whose country holds the EU's rotating presidency, said on Friday.
"If I understand it rightly, it is a rather serious step," he said. "If that is the decision that will be taken by the Israeli government, we will most certainly express our views on it."
The issue of Israeli settlements on occupied Palestinian land is one of the thorniest in the stalled Middle East peace talks.