Israel on Monday strongly rejected criticism from the United States and European Union over the demolition of a well-known East Jerusalem hotel to make way for settler homes.

"Calling Jerusalem a settlement is a misinterpretation, an insult to the history of the city," Israeli Foreign Ministry spokesman Yigal Palmor told AFP.

"It is incomprehensible that they are mixing questions of private rights, international law and politics," he added.

The EU's foreign policy chief Catherine Ashton on Sunday "strongly" condemned the demolition of the Shepherd Hotel, which is being torn down to make way for the construction of 20 settler homes in the Sheikh Jarrah neighbourhood of occupied East Jerusalem.

"I reiterate that settlements are illegal under international law, undermine trust between the parties and constitute an obstacle to peace," Ashton said. "Furthermore, we recall that East Jerusalem is part of occupied Palestinian territory; the EU does not recognise the annexation by Israel."

Palmor also rejected criticism by US Secretary of State Hillary Clinton, who called the demolition a "disturbing development" that undermines efforts to achieve a two-state solution.

He said the hotel was on "private land, the development of which has nothing to do with diplomacy."

On Sunday morning, three bulldozers worked to bring down part of the dilapidated hotel, which was once home to Jerusalem's Muslim leader, Mufti Haj Amin al-Husseini, infamous for his ties to Nazi leader Adolf Hitler.

Though East Jerusalem is largely Palestinian, an increasing number of hard-line Israeli settlers have moved into the area's neighbourhoods, sparking fights with Arab residents.

The Palestinians regard East Jerusalem as the capital of their future state and fiercely oppose any attempts to extend Israeli control over it.

Israel captured East Jerusalem in the 1967 Six Day War and later annexed it in a move the rest of the world never recognised. The Jewish state considers the whole of Jerusalem its "eternal and indivisible" capital.

Egypt and Jordan have warned in separate statements the hotel's demolition could fuel unrest in the Palestinian territories. It could lead to "a new explosion of violence," the Egyptian foreign ministry said in a statement issued late Sunday in Cairo.

It accused Israel of attempting to "Judaise the Holy City and empty it of its Palestinian residents."

Israel will be held responsible for its "provocative policies," it added.

Jordanian Foreign Minister Nasser Judeh also issued a harsh statement saying the Amman government "rejects and strongly denounces" Sunday's demolition work which could lead to "instability."

Jordan urged the international community to intervene and said Israel's action undermines peace efforts.