The announcement, analysts said, was a slap to a US administration that had persuaded Palestinians to return to talks despite their anger with Washington's decision to drop initial calls for Israel to halt all settlements.
President Barack "Obama did not want nor need a fight with Israel right now. He had other priorities," said Aaron David Miller, a former Middle East peace negotiator in past Republican and Democratic administrations.
"This is a huge problem for the Obama administration. Their options are very bad," Miller told AFP.
"If they escalate this situation by continuing a war of words or by trying to impose some kind of accountability... they will lose the proximity (indirect) talks which they've worked so hard to begin," Miller said.
By accountability, he meant the denial of US aid to Israel or some other measure, according to Miller, now a scholar at the Woodrow Wilson International Center for Scholars in Washington DC.
The other option for Obama is to "live to fight another day and save his pressure and his firmness for an issue like borders (of a future Palestinian state), which is going to come up during the proximity talks," he said.
Miller also warned that a simmering dispute could complicate the US strategy to press other world powers into imposing a fourth round of UN Security Council sanctions on Iran over its nuclear ambitions.
Haim Malka, an analyst with the Center for Strategic and International Studies (CSIS), said the settlement move was "more about Israeli coalition politics than diplomacy" because the Shas Party controls the interior ministry.
The ministry was "essentially firing a shot across (Israeli Prime Minister Benjamin) Netanyahu's bow" not to negotiate over Jerusalem, a Shas party plank.
"If Netanyahu is at all serious about talks with the Palestinian Authority, this will be just the beginning of his coalition woes," Malka warned.
"Meanwhile, the Israeli bilateral relationship with the United States has just become much more difficult," he said on the CSIS website.
Daniel Kurtzer, a former US ambassador to Egypt and Israel, predicted the row will in the long run amount to a "small bump in the road" toward restoring US-Israeli ties and advancing the very modest indirect talks.
Nevertheless, Kurtzer, who now teaches at Princeton's Woodrow Wilson School of Public and International Affairs, pointed out the US-backed Palestinian Authority is troubled by the settlement announcement.
"Getting these things off the ground is still not assured," Kurtzer told AFP.
If and when they are launched, US officials will have to apply "some really deft diplomacy" to make progress, especially since the Arab League has given the talks only four months to produce results, he said.
Shortly after he spoke, the Arab League said there should be no talks, direct or indirect, unless Israel halts plans to build 1,600 settler homes in annexed east Jerusalem.
Shibley Telhamy, a Middle East scholar at the University of Maryland, said Biden's condemnation of Israel has given Mahmud Abbas, the Palestinian leader, enough cover to pursue the indirect talks.
"But I think everybody is scratching their heads because the bottom line issue is what if this happens again in two weeks," he warned.
Most analysts have faulted the way the Obama administration has handled the thorny settlement issue from the start, given how difficult it would be to get Netanyahu's right-wing coalition government to agree.
And Kurtzer noted that the Israelis are a "bit oversensitive" that Obama has already visited three key Muslim countries -- Egypt, Saudi Arabia and Turkey -- without having traveled to the Jewish state, Washington's closest ally.
"He should find a way to get there soon. It's not going to make up for the year of all this griping, but still it will put this issue somewhat behind us," Kurtzer said.
He said the Obama team had somewhat "squandered" the political capital it enjoyed from American Jews and Congress after the 2008 election and only added to concerns Israelis had about him as a presidential candidate.
"So far the peace process has not been one of the star attractions in the administration's portfolio," Kurtzer said.
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