Arabs fear that Israeli settlement building on land captured in the 1967 Middle East war, including East Jerusalem, has made a two-state solution backed by the United States unfeasible.
Qatar's emir, Sheikh Hamad bin Khalifa Al-Thani, offered to contribute $250 million to the fund, which he suggested at an Arab summit in Doha that focused on the crisis in Syria and stalled Israeli-Palestinian peace efforts. "(Jerusalem) is in serious danger, which requires of us serious action. Palestinian, Arab and Islamic rights in Jerusalem cannot be compromised. Israel must realize this," Sheikh Hamad said.
He did not elaborate on the precise purpose of the fund and how the money would be spent.
The fate of Jerusalem has proved one of the thorniest sticking points in past Middle East peace negotiations. Citing Jewish Biblical ties to the holy city, Israel annexed the Arab eastern sector and its surroundings in 1980 in a move rejected by the United Nations Security Council.
The Palestinian Authority (PA), which administers parts of the Israeli-occupied West Bank, is in deep financial crisis.
On Friday the United States promised $500 million in aid to the PA, and Israel pledged to resume transferring $100 million in monthly tax revenue it collects on the Palestinians' behalf. Qatar's emir did not say if the proposed Arab fund would be channelled to the PA, whose writ does not run in East Jerusalem.
About 200,000 Israelis live in the annexed part of Jerusalem, including more than 1,000 in and around the mostly Arab Old City.
Palestinian officials are sceptical of Arab aid pledges, as few Arab countries carried through on promises last year to cover a Palestinian funding gap aggravated by Israeli sanctions.
Last year Arab donations, including $200 million from Saudi Arabia, constituted almost half the PA's foreign aid, with the United States and European Union providing around $330 million. "As we've have seen many times before, unfortunately decisions in Arab summits often do not materialise on the ground," said Ghassan Shaka, a senior member of the Palestine Liberation Organisation.
"Financing is just a means, political help is the important thing," he said. "The Arab world must convince and apply pressure so the world knows what's required for peace."