The new housing would expand Har Homa, a Jewish neighborhood in an area Palestinians claim as capital of a future state. Palestinian officials appealed to the U.S. to block the project.
The Israeli announcement focused attention on one of the most difficult issues facing Israeli and Palestinian negotiators in peace talks that are supposed to resume this month - the future of Jerusalem.
Housing Ministry spokesman Kobi Bleich said 307 housing units would be built Har Homa. About 4,000 Israelis live there now.
Also Tuesday, Israel pledged to press ahead with its campaign against militants in Gaza, responding to almost daily rocket barrages at Israel. The military said that on Tuesday, 21 rockets and mortars were fired at Israel by nightfall, bringing the 12-month total over 2,000.
Defense Minister Ehud Barak said it is time to "kill those who carry out attacks" against Israelis, but said he was holding off on a large-scale invasion of the Gaza Strip for now.
Barak told Army Radio that Israeli troops killed 27 Gaza militants in the past 10 days and would continue to chase down those operating under Hamas rule.
Early Tuesday, an Israeli airstrike on a Hamas police post in central Gaza killed three militants and wounded a fourth.
Har Homa is just inside the expanded city limits of Jerusalem, drawn after Israel captured east Jerusalem in the 1967 war. Israel annexed east Jerusalem days after the war, but no country recognized that.
Israeli Prime Minister Ehud Olmert has indicated willingness to withdraw from some Arab neighborhoods that fall within the expanded Jerusalem boundaries. But in principle, he backs the long-standing Israeli policy that the whole city is the capital of Israel.
That includes the most hotly contested site, a hilltop in the Old City where the Al Aqsa Mosque compound was built on top of the ruins of the biblical Jewish temples. Neither side has shown any inclination to compromise there.
Since 1967, Israel has built a string of Jewish neighborhoods in east Jerusalem, with about 180,000 residents. Har Homa, at the southern edge of the city line, is the newest.
Palestinians object to Israeli construction in east Jerusalem, pointing to the internationally backed "road map" peace plan, which is the basis of renewed negotiations agreed on at the Mideast summit last week in Annapolis, Maryland, sponsored by U.S. President George W. Bush.
The road map's first phase bans building in Israeli settlements in the West Bank. Palestinian negotiator Saeb Erekat said he sent an urgent message to U.S. Secretary of State Condoleezza Rice, asking her to block the new construction. "This is undermining Annapolis," he said.
"Israel's ever-expanding settlement enterprise in the occupied Palestinian territory poses the single greatest threat to the establishment of an independent, viable and contiguous Palestinian state, and hence, to a just and lasting peace between Israelis and Palestinians," Erekat said.
However, Israel contends that the construction ban is irrelevant. "Israel makes a clear distinction between the West Bank and Jerusalem," said Mark Regev, spokesman for Prime Minister Ehud Olmert. "Israel has never made a commitment to limit our sovereignty in Jerusalem. Implementation of the first phase of the road map does not apply to Jerusalem."
Chief Palestinian negotiator Ahmed Qureia rejected that. "Jerusalem is part of the Palestinian territories, and (Israel) should not build settlements on it, the same as the other areas occupied in 1967," he said.
The road map says the status of Jerusalem should be negotiated in the final stage of the three-step plan.
The Israeli settlement watchdog group Peace Now charged in a report Tuesday that Israel is not enforcing its own construction laws in the West Bank. According to the report, only 107 illegal structures have been taken down in the settlements, though 3,449 demolition orders have been issued.
Besides the settlement construction freeze, the road map also requires Israel to remove dozens of unauthorized outposts in the West Bank and obligates the Palestinians to rein in militants who attack Israel. Neither side fulfilled the plan's initial requirements, stalling the 2003 plan.
Palestinian President Mahmoud Abbas has been tightening his control of the West Bank in the aftermath of the Hams takeover of Gaza in June. As a test, last month police loyal to Abbas deployed in the city of Nablus, where the Israeli military was in control.
On Tuesday, Palestinian police set up roadblocks around the town of Tulkarem, near the line between the West Bank and Israel. Police searched for unlicensed guns and stolen cars in a government crackdown on militant activity and crime.