JERUSALEM: Israeli building on occupied land poses the most serious threat to the creation of a Palestinian state, EU diplomats said in a report leaked on Wednesday, urging Europe not to fund any settlement activities.

The non-binding document by European Union consul generals in East Jerusalem and the West Bank, territory captured in a 1967 war, said the 27-nation bloc should be diligent in ensuring settlements are excluded from trade benefits enjoyed by Israel.

"settlement construction remains the biggest single threat to the two-state solution. It is systematic, deliberate and provocative," said the internal report that was sent to Brussels for consideration earlier this month.

Israeli leaders have repeatedly spurned international calls to stop settlement activity on land Palestinians seek for a future state. Citing historical and Biblical links to Jerusalem and the West Bank, Israel says it has a right to build there.

The report denounced Israel's treatment of Palestinians in East Jerusalem. It also urged EU states "not to support ... research, education and technological cooperation" and to discourage investment in Israeli firms operating in occupied territory.

European countries, the report added, should consider barring entry to their territory of "known violent settlers".

Yigal Palmor, an Israeli Foreign Ministry spokesman, said the document would not help efforts to further peace.

"A diplomat's mission is to build bridges and bring people together, not to foster confrontation. The EU consuls have clearly failed in their mission," he said.

Senior Palestinian politician Hana Ashrawi welcomed the report and urged EU states to heed its recommendations.

"Now is the time to exercise the political will that is required to hold Israel accountable before any and all chances for peace are destroyed," she said in a statement.

Palestinian-Israeli peace talks broke down in 2010 after Israel ended a partial moratorium on settlement construction.

Some 325,000 Jewish settlers live in the West Bank and a further 200,000 reside in East Jerusalem. Some 250,000 Palestinians also live in Jerusalem, which Israel annexed after 1967 in a move that was never internationally recognised.

The EU envoys said Arabs faced persistent problems in the city, including demolitions and evictions, "restrictive" planning, "discriminatory access" to religious sites, "inequitable" education and "difficult access" to health care.

The report identified construction in large urban settlements that lie between Jerusalem and the Palestinian West Bank town of Bethlehem as "the most significant and problematic plans" that Israel was currently advancing.

Israeli Prime Minister Benjamin Netanyahu, defying international condemnation, has also pledged to build more than 3,000 settler homes in the so-called E1 corridor near Jerusalem.

The report said building in E1 "is set to cut off East Jerusalem from the rest of the West Bank". Israel, which announced the project after the United Nations granted de facto recognition to a Palestinian state last November, has said construction in the area is at least a year away.