Hawkish Prime Minister Benjamin Netanyahu said the government was not going to place restrictions on Jewish residents in a city that the state considers its capital.

"We cannot accept the idea that Jews will not have the right to live or to build anywhere in east Jerusalem. We cannot accept such restrictions," Netanyahu said at the start of the weekly cabinet meeting.

"Unified Jerusalem is the capital of the Jewish people and the state of Israel. Our sovereignty over it is unquestionable," he said, adding that the city′s Palestinian residents could buy houses throughout the city.

Israel′s ambassador in Washington Michael Oren was summoned to the State Department at the end of last week and was told the project, which aims to build housing units in the Sheikh Jarrah neighbourhood, should be be halted, an Israeli official told AFP, speaking on condition of anonymity.

There was no immediate US comment on the reports.

The project is on the site of the former Shepherd Hotel, which was bought in 1985 by American millionaire Irving Moskowitz, who has previously financed settlement projects in east Jerusalem and the occupied West Bank, according to local Israeli media.

The project received a building permit from the Jerusalem municipality three months ago, said the Maariv daily.

The site is located near Israeli government buildings and the British and US consulates in east Jerusalem.

The international community considers Jewish neighbourhoods in mostly Arab east Jerusalem to be Israeli settlements and the issue is one of the main obstacles in the hobbled Middle East peace process.

Israel captured east Jerusalem from Jordan in the 1967 Six Day War and later annexed that part of the city in a move not recognised by the international community. It sees all of Jerusalem as its "eternal, undivided" capital and does not consider construction in east Jerusalem to be settlements.

The Palestinians want to make east Jerusalem the capital of their promised state and vigorously oppose all settlement construction in east Jerusalem, home to some 200,000 Jewish Israelis and 268,000 Palestinians.

Under new US President Barack Obama, Washington has repeatedly pressed Israel to stop all settlement activity, something that hawkish Israeli Prime Minister Benjamin Netanyahu has so far refused to do.

The Palestinians have refused to re-start peace negotiations with the Israelis unless the Jewish state stops all settlement activity.