Egypt has said a new Israeli law that retroactively legalises thousands of  settler homes built on privately owned Palestinian land harms prospects for a two-state solution to the Palestinian-Israeli  crisis.

The law, which the Israeli parliament passed on Monday, has faced a flurry of international criticism from countries including Britain, France and neighbouring Jordan, as well as the United Nations.

Egypt's foreign ministry said in a statement late Tuesday that the legislation "undermines opportunities for a two-state solution and entrenches the illegal status of the settlements in violation of relevant international laws and norms and decisions by the [United Nations] Security Council."

"Taking such one-sided steps would impede efforts to revive the peace process and resume direct negotiations between the Palestinian and Israeli sides," the ministry said.

The move also represents an "encroachment on the right of the Palestinian people to establish their state on their entire territory with a capital in east Jerusalem," it added.

The legislation would legalise dozens of outposts and thousands of settler homes in the occupied West Bank and has been condemned by Palestinians as a blow to their hopes for statehood. It also prompted a call by the Palestinians for the international community to punish Israel.