Israel's settlement construction in annexed east Jerusalem is part of a strategy aimed at preventing the Holy City from becoming the capital of two states, an internal EU report found on Wednesday.

In its Jerusalem Report 2012, a copy of which was seen by AFP, the European Union said Jewish settlement construction posed "the biggest single threat to the two-state solution."

Describing Israel's settlement construction in east Jerusalem as "systematic, deliberate and provocative" the report accused the Jewish state of making deliberate political choices that threatened to render the two-state solution impossible.

Relations between Israel and the EU have been particularly tense in recent months, with Europe voicing increasing discontent over a raft of Israeli plans to build more than 5,000 new settler homes in and around annexed east Jerusalem.

The standoff has sparked Israeli concerns the 27-member bloc, its largest import and export market, could move to implement a series of punitive trade sanctions.

Authored by EU heads of mission in Jerusalem and Ramallah, the report flagged construction in three southern areas -- Har Homa, Gilo and Givat HaMatos -- as being the "most significant and problematic plans".

"The construction of these three settlements is part of a political strategy aiming at making it impossible for Jerusalem to become the capital of two states," it warned.

"If the current pace of settlement activity on Jerusalem's southern flank persists, an effective buffer between east Jerusalem and Bethlehem may be in place by the end of 2013, thus making the realisation of a viable two-state solution inordinately more difficult, if not impossible."

In 2012, tenders were issued for 2,366 new units which was "more than twice" the total number issued over the preceding three years which stood at 1,145, the report said.

Most of them were for construction in Har Homa, thereby "significantly expanding the existing footprint of the settlement's built-up area."

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

It considers all of Jerusalem its "eternal, undivided" capital and does not see construction in the eastern sector as settlement building.

But the Palestinians want east Jerusalem for the capital of their promised state, and they -- along with the international community -- consider settlement construction in east Jerusalem and the West Bank as a violation of international law.

"If the implementation of the current Israeli policy regarding the city continues, particularly settlement activity, the prospect of Jerusalem as a future capital of two states -- Israel and Palestine -- becomes practically unworkable," the executive summary said.

"This threatens to make the two-state solution impossible."

The report also flagged Israel's decision to push forward with plans to build 3,426 units in E1 -- a deeply sensitive area of the West Bank just east of the Holy City where experts say construction would isolate Arab east Jerusalem and cut the West Bank in two.

"The implementation of the E1 project, which threatens 2,300 Bedouin with forcible transfer, would effectively divide the West Bank into separate northern and southern parts," it warned.

"It would prevent Palestinians in east Jerusalem from further urban development and cut off east Jerusalem from the rest of the West Bank."

The decision to halt or approve construction was a political choice which was illustrated by the "temporary dip" at the start of 2012 as Israeli and Palestinian negotiators held informal talks in Amman, it said.

"Similarly, the surge in settlement activity in late 2012 was also a matter of political choice .. following the Palestinian upgrade at the United Nations," the EU said, referring to Israel's approval of more than 5,000 east Jerusalem settler homes in December.

The EU also flagged an increase in violent confrontations between Jews and Muslims at the Al-Aqsa mosque compound in Jerusalem's Old City.

The plaza houses the third holiest site in Islam, but is also revered by Jews as the site of two former Temples, with the report noting tensions had risen over the "sharp rise" in visits by radical political and religious Jewish groups, often in a "provocative" manner.

"With the peace process at an impasse and the region in transition, this increases exponentially the risk of a new crisis erupting over the site," it warned.