Netanyahu's defiant stance set the stage for a possible showdown with President Barack Obama, who, in talks with the new Israeli prime minister in Washington last week, pressed for a halt to all settlement activity, including natural growth, as called for under a long-stalled peace "road map."

"The demand for a total stop to building is not something that can be justified and I don't think that anyone here at this table accepts it," Netanyahu told his cabinet, referring to Jewish settlements in the West Bank, according to an official.

Netanyahu said Israel had no plans to set up any new West Bank settlements but, he told Obama, according to the official, that his government "does not accept limitations on building" within what Israel defines as its capital, the Jerusalem municipality, an area that includes Arab East Jerusalem and parts of the West Bank captured in a 1967 Middle East war.

Palestinians want their own state in the West Bank and the Gaza Strip with its capital in Jerusalem. Settlement building in the city is a particularly sensitive issue for both sides.