President Barack Obama led world powers on Tuesday in criticising Israel's decision to build 1,300 settler homes in east Jerusalem, warning it risks wrecking an already fragile peace process with the Palestinians.

"This kind of activity is never helpful when it comes to peace negotiations," Obama told reporters during a visit to Indonesia.

"I'm concerned that we're not seeing each side make the extra effort to get a breakthrough that could finally create a framework for a secure Israel living side-by-side in peace with a sovereign Palestine," the US leader said.

But he said he would continue working on the process despite the deepening impasse. "We're going to keep on working it though because it is in the world's interests," he said.

The foreign ministry in Russia, a member of the Middle East peace Quartet along with the United States, United Nations and European Union, said: "Moscow treats this decision with the most serious concern.

"We find it essential that the Israeli party refrained from the declared construction and on the whole kept to a moratorium on settler activity on the west bank of the Jordan river and in east Jerusalem."

British Foreign Secretary William Hague said the Israeli announcement on Monday of the east Jerusalem plan was "extremely disappointing and unhelpful."

"As I made clear during my recent visit to Israel and the occupied Palestinian territories settlements are an obstacle to peace," he said. "Their construction should stop."

In the face of the criticism, Israel insisted it would never limit construction in its "capital," having annexed east Jerusalem to reunite the Holy City in a move not recognised by the international community.

"Israel sees no connection between the peace process and the planning and building policies in Jerusalem that have not changed for the last 40 years," said Prime Minister Benjamin Netanyahu's office.

"Jerusalem is not a settlement -- Jerusalem is the capital of the state of Israel," it said, adding no Israeli government had ever curbed building in the city since seizing and annexing the eastern sector during the 1967 Six-Day War.

"Building in Jerusalem has never interfered with the peace process," it said, while admitting that differences with Washington over Jerusalem had persisted over the past four decades.

Israel's decision to approve the new homes in mainly Arab east Jerusalem sparked a furious reaction from the Palestinians, who accused Netanyahu of being determined to sabotage peace talks.

Chief Palestinian negotiator Saeb Erakat on Tuesday called on the international community to move toward recognition of a Palestinian state in response to the Israeli defiance.

"This latest unilateral Israeli act necessitates dramatic international action for immediate recognition of the Palestinian state (based) on the June 4, 1967 borders," he said.

Netanyahu himself, on a visit to the United States, the main broker of the peace process, urged Palestinians to return to the negotiating table, warning that the Jewish state would not yield to international dictates.

EU chief diplomat Catherine Ashton joined the calls for Israel to drop the settlement plans in east Jerusalem, warning its decision clashed with efforts to revive peace talks with the Palestinians.

"Catherine Ashton is extremely concerned by the announcement by Israel of a plan for the construction of 1,300 new housing units in east Jerusalem," her office said.

Direct talks resumed on September 2 but quickly ran aground when an Israeli moratorium on West Bank settlement construction expired later that month, prompting the Palestinians to freeze talks until Israel reimposes the ban.

The US State Department said Secretary of State Hillary Clinton would address the issue of east Jerusalem settlements when she meets Netanyahu in New York on Thursday.

Netanyahu also hit a barrage of UN criticism, with United Nations chief Ban Ki-moon expressing concern to the right-wing Israeli leader in a meeting at the organisation's headquarters in New York.

Ban "expressed concern at the resumption of the settlement activity and recent announcements of further settlement construction in east Jerusalem," a UN spokesman said.

And Ekmeleddin Ihsanoglu, the Organisation of the Islamic Conference head, urged the international community "to oblige Israel to put an end to all forms of settlement building that damages the inalienable rights of the Palestinians.