The project is likely to spark condemnation from the international community, which has repeatedly called on Israel to avoid new building projects in mainly Arab east Jerusalem.
Jerusalem's municipal council in a statement confirmed the project, but said it was part of a long-standing policy to expand housing availability for the city's Jewish and Arab residents.
"There has been no change in the policy towards construction in Jerusalem for the last 40 years," it said. "The Jerusalem municipality continues to promote both Jewish and Arab construction in the city."
Gilo is one of the first and largest Jewish neighbourhoods in Jerusalem that Israel has built on land captured in the 1967 Six-Day War. It lies on the southern edge of the city, next to the West Bank town of Bethlehem.
The project drew immediate criticism from Israeli left-wing politicians and activists, as well as Palestinian condemnation.
"We strongly condemn this Israeli escalation and continued decisions in the area of settlements and the imposition of new facts on the ground," chief Palestinian negotiator Saeb Erakat told AFP.
"I think it's the time for the US administration to officially hold the Israeli government responsible for the collapse of the peace process."
US-brokered peace negotiations between Israel and the Palestinians have deadlocked over the issue of Jewish settlement in the occupied West Bank and east Jerusalem.
The Palestinians walked out of direct peace talks three weeks after they started in September when Israel baulked at extending a 10-month partial freeze on settlement construction in the West Bank.
They refuse to negotiate with Israel while it builds on land they want for a future Palestinian state.
Yariv Oppenheimer, the secretary general of Peace Now, an Israeli NGO opposed to settlement building, said he was "deeply concerned" by the planned project.
"Not only will it damage the chances of reaching an agreement on the Jerusalem issue, it might also create an international problem for Israel in its legitimacy abroad," he told AFP.
But Science and Technology Minister Daniel Hershkowitz of the rightwing settler party Habait Hayehudi said the project was legitimate and Israel would not stop construction in the Holy City.
"Even if there was a moratorium (on settlement building), it would not include Jerusalem," he said ahead of Israel's weekly cabinet meeting.
"It's part of Jerusalem, so there is no moratorium whatsoever and Israel is going to continue building in its capital."
Elisha Peleg, a municipal council member from the rightwing Likud party of Prime Minister Benjamin Netanyahu, also praised the project, saying Gilo "is an integral part of Jerusalem."
"There can be no argument in Israel over construction in that neighbourhood," he told Israeli radio.
In March 2010, the interior ministry announced a plan to build 1,600 settler homes in Ramat Shlomo, an Orthodox Jewish neighbourhood in east Jerusalem.
The announcement, which came as US Vice President Joe Biden was visiting Israel, provoked fierce American opposition and soured relations with Washington for several months.
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