It found settlement construction in East Jerusalem and the West Bank was “the biggest single threat to the two-state solution”, describing it as “systematic, deliberate and provocative”.

Israel was trying to drive Palestinians out of East Jerusalem with restrictive zoning and planning, demolitions and evacuations, discriminatory access to religious sites, an inequitable education policy, difficult access to health care and inadequate provision of resources, the report said.

The EU Heads of Mission Jerusalem Report recommends sanctions against settlements in East Jerusalem and the West Bank to “prevent, discourage and raise awareness about problematic implications of financial transactions including foreign direct investments, from within the EU in support of settlement activities, infrastructure and services.”

It says every effort must be made to ensure products manufactured in settlements do not receive preferential treatment or tariffs and that they are correctly labelled as settlement goods.

Israel would not provide any response to the non-binding EU report, written by consuls in Jerusalem and Ramallah and seen by Fairfax Media. A Foreign Ministry spokesman told Fairfax Media: “They have never presented it to us, so we cannot comment on it.”

The report highlighted what it labelled as the “most significant and problematic” settlement plans in East Jerusalem, including the expansion of Har Homa and Gilo and the building of Givat Hamatos.

It is also deeply critical of the plans to construct the settlement known as E1 – announced by Prime Minister Benjamin Netanyahu in response to the UN vote to upgrade Palestine to a “non-member observer state” last November.

“Together these settlements will form an Israeli buffer that once complete will virtually cut off East Jerusalem's southern flank from Bethlehem and the southern West Bank,” the report reads.

“The construction of these three settlements is part of a political strategy aimed at making it impossible for Jerusalem to become the capital of two states.”

It accused successive Israeli governments of pursuing a policy of transferring the Jewish population into the West Bank and East Jerusalem “in violation of international humanitarian law”.

“Out of a total of more than 500,000 Israeli settlers living in the Occupied Palestinian Territories, around 200,000 now live in settlements inside East Jerusalem,” the report found.

The report, which was delivered to the EU in Brussels and to the relevant foreign ministries of its 27 member states in January, also advocates closer supervision of joint Israel-EU technological research and development programs to ensure research grants, scholarships or other technological investments do not assist settlements.

Palestinian leaders welcomed the strongly-worded report from the EU counsels general, calling on the European Union and its members to “stand up to Israel”.

“With Israel's most recent escalation of settlement activities in and around Jerusalem, the rise of settler violence and Israeli violations of international law and Palestinian rights, it is of utmost urgency for European countries to follow this courageous assessment with concrete and tangible steps and with punitive measures,” said PLO Executive Committee member, Hanan Ashrawi.

“Israel's settlement campaign is the single most significant threat to the two-state solution, and 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,” Dr Ashrawi said.

Israel captured east Jerusalem during the 1967 Six Day War and subsequently annexed it in a move that has never been recognised by the international community.