"Jerusalem is not a settlement -- Jerusalem is the capital of the state of Israel," it said, adding that no Israeli government had ever curbed building in the Holy City since taking over 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 been ongoing over the last 43 years.
Speaking later to Fox Business Network from the United States, Netanyahu said the settlement issue was "overblown."
"That will be an issue that we'll discuss but I think it's overblown," he said.
"You are talking about a handful of apartments that really don't affect the (peace) map at all contrary to impressions that might be perceived from certain news reports. So it's a minor issue that might be turned to a major issue."
Plans to increase building in east Jerusalem were made public on Monday as Netanyahu was on a five-day trip to the United States to discuss a revival of moribund peace talks with the Palestinians.
The announcement prompted a livid response from the Palestinians, who accused Israel of a bald-faced attempt to sabotage peace talks between the two sides, which began in early September but ran aground some three weeks later.
"Once more, at the moment that we expected Prime Minister Netanyahu to announce a full settlement freeze... he has sent Palestinians and the US administration a clear message that Israel chooses settlements, not peace," chief Palestinian negotiator Saeb Erakat said on Tuesday.
The world must answer Israel's defiance by recognising a Palestinian state, he said.
"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.
The Palestinians have repeatedly threatened to go to the United Nations for recognition of a Palestinian state if peace talks fail, but Israel has cautioned against any unilateral moves, saying the only way to peace is through a negotiated agreement.
The decision to build more homes in occupied annexed east Jerusalem sparked a sharply worded condemnation from global powers, with US President Barack Obama remarking: "This kind of activity is never helpful when it comes to peace."
The Jerusalem plans were likely to play centre stage when Netanyahu meets US Secretary of State Hillary Clinton in New York on Thursday, although the Israeli leader's office insisted he would use the meeting "to advance peace talks."
Israel seized mostly-Arab east Jerusalem in the 1967 Six Day War and annexed it shortly afterwards in a move not recognised by the international community or the Palestinians, who consider it the capital of their promised state.
The Palestinians see the settlements as a major threat to the establishment of a viable state, and they view the freezing of settlement activity as a crucial test of Israel's intentions.
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