In its Jerusalem Report 2012, a copy of which was seen by AFP, the European Union said Jewish settlement construction posed "the biggest single threat to the two-state solution".

It outlined a series of recommendations urging member states to halt or avoid any financial investment or transactions that could directly or indirectly feed into Israel's settlement-building enterprise - effectively calling for economic sanctions.

Written by the EU heads of the mission in Jerusalem and Ramallah, the strongly worded report described Israel's settlement construction in East Jerusalem as "systematic, deliberate and provocative", accusing the Jewish state of making deliberate political choices that threaten to render the two-state solution impossible.

An Israel spokesman dismissed the report, saying it showed that the Europeans had failed in their diplomatic mission.

"A diplomat's mission is to build bridges and not to encourage confrontation," Israeli Foreign Ministry spokesman Yigal Palmor told AFP. "These consuls have failed in their diplomatic mission."

But the Palestinians hailed the report, with senior official Hanan Ashrawi saying it was a "responsible assessment" of Israeli actions in east Jerusalem.

"It is ringing an alarm concerning the destructive nature of the Israeli policies and its dangerous implications for peace," she said.

"We hope that this report will be adopted by Brussels and implemented individually and collectively in concrete and tangible steps to hold Israel accountable," she said.

European officials said on Wednesday the recommendations are part of a non-binding internal report for European governments in their briefings on the Middle East peace process. The diplomats represent 22 countries, including Germany, France and the UK.

Parts of the report were published in the Israeli daily Haaretz. EU officials confirmed the report. They spoke on condition of anonymity because they were discussing a confidential internal document.

The diplomats also recommend European countries step up efforts to label settlement-made products sold in Europe.

The EU says Israeli settlements are illegal.

Relations between Israel and the EU have been unusually tense in recent months, with Europe voicing anger over a swathe of Israeli plans for more than 5,000 new settler homes in East Jerusalem.

In the 15-page report, EU diplomats flagged construction on the southern flank of east Jerusalem - in Har Homa, Gilo and Givat HaMatos - as being the "most significant and problematic" saying that if it continued unabated, it would likely cut the area off from Bethlehem by the end of the year. "The construction of these three settlements is part of a political strategy aiming at making it impossible for Jerusalem to become the capital of two states," it warned.

"If the current pace of settlement activity on Jerusalem's southern flank persists, an effective buffer between east Jerusalem and Bethlehem may be in place by the end of 2013, thus making the realization of a viable two-state solution inordinately more difficult, if not impossible."

AFP-AP