Israel has rejected calls by the US to suspend a planned housing project in East Jerusalem, positioning the two allies for a potential standoff over settlement construction.

Israeli officials said on Sunday that Michael Oren, the country's ambassador to Washington, had been summoned to the state department and told that a project in the disputed section of the holy city should be abandoned.

According to the Israeli Army Radio, the US has demanded that planning approval for the project, which is being developed by an American millionaire, be revoked.

But Binyamin Netanyahu, the Israeli prime minister, rejected the US demands, telling a cabinet meeting on Sunday that there would be no limits on Jewish construction anywhere in "unified Jerusalem".

"We cannot accept the fact that Jews wouldn't be entitled to live and buy anywhere in Jerusalem," Netanyahu declared, calling Israeli sovereignty over the entire city "indisputable".

Controversial project

Granted by the Jerusalem municipality earlier this month, the planning approval  for the controversial project allows the construction of 20 apartments plus a three-level underground parking lot that will replace the Shepherd Hotel.

Saeb Erekat, the chief Palestinian negotiator, said: "If the Israeli prime minister continues with settlement activities, he will undermine the efforts to revive the peace process."

Most international powers also considers Jewish neighbourhoods in East Jerusalem to be settlements and an obstacle to Israeli-Palestinian peacemaking.

Settlements have emerged as a major sticking point in relations between Israel and the administration of Barack Obama, the US president, because of their potential to disrupt Middle East peacemaking.

'Head-on collision'

Although Netanyahu recently yielded to US pressure to conditionally endorse the establishment of a Palestinian state, he has consistently resisted US demands for an immediate freeze on settlement expansion.

Speaking to Al Jazeera, Akiva Eldar, chief political columnist for the Israeli newspaper Haaretz, said the dispute was an example of how settlement building had become a publicly acknowledged obstacle to the peace process.

"I think the high profile that both Israel and the United States, as well as the Arab countries and particularly the Palestinians, have put on the settlements is offering a good potential for a head-on collision," he said.

"According to the official Israeli position, it's not illegal and even the United States, for many years, and even now, is not making a point of the legal issues, they're just saying its not helpful ... but no country, not even the United States, has recognised [Israel's] annexation of East Jerusalem."

Israel annexed East Jerusalem and declared all of the city its capital after the 1967 war.

Ziad al-Hammouri, the director of the Jerusalem Centre for Social and Economic Rights, told Al Jazeera: "What's happening in Jerusalem today ... is illegal. East Jerusalem is a part of the occupied territories which has to be given back and form part of a Palestinian state."

The centre provides legal assistance to Palestinian residents of East Jerusalem.