"It is disinformation," said Danny Seidemann, a civil rights lawyer contesting the Har Homa project.
"Four times the government has promised more building permits for Palestinians in Jerusalem as a quid pro quo for the building of a settlement.
"In 1980, some 18,000 permits were pledged, but 17 years later we have yet to see a single one."
In a bid to placate critics of his plan to build 6,500 apartments for Jews at Har Homa between Jerusalem and Bethlehem on land captured by Israel in 1967, Mr Netanyahu said the government had allocated $42m (pounds 26m) for housing for Palestinians in 10 East Jerusalem neighborhoods over the next three years.
Since 1967, Palestinians in the city have been able to build only 9,000 apartments, compared to 64,000 built for Jews - 39,000 of which are on expropriated land.
In reality Mr Netanyahu, wishing to appear even-handed to an international audience, has recycled an existing plan to build sewers, water pipes and roads in Palestinian areas in East Jerusalem.
Once this is done, Palestinians will be able to apply for the 3,015 building permits to build houses privately.
"Contrary to the impression left by most of the media," wrote the daily Haaretz yesterday, "there has been no decision to directly build residential units for Arabs, but only to invest in infrastructure."
Israeli policy is to maintain a ratio of 72 per cent Jews and 28 per cent Palestinians in the 600,000 population of Jerusalem.
Palestinians allege that this has been done through restricting their access to housing and by gerrymandering the municipal boundaries of the city to exclude Palestinian towns and villages.
In the metropolitan area of Jerusalem as a whole, the Palestinian population is about 55 per cent of the total.
Diplomats in Jerusalem say they are also concerned that the Israeli Interior Ministry is casting doubts on the validity of the Jerusalem residency permits of 120,000 out of 170,000 Palestinians in the city.
Yasser Arafat, the Palestinian leader, reacted cautiously yesterday to the Har Homa decision, probably because he wants to discourage any confrontation as he prepares to go to Washington to see President Clinton next week.
Visiting the West Bank town of Nablus yesterday, he said: "This is a big breaching to what had been agreed upon and it is against the United Nations resolutions and also against the American letter of guarantee."
Asked if big protests were planned Salah al-Tamaari, a member of the Palestinian Council co-ordinating protests against Har Homa, said: "We don't want to consume the energies of our people all at once.
"Things will accumulate. Arafat always responds to the mood of the people."
He said the settlement would cut off Palestinians in Jerusalem from those outside, and cut the West Bank in two.
Abroad, Israel has been criticised throughout the world, but probably no more strongly than Mr Netanyahu expected.
At the same time there is little doubt that he would have preferred not to have started, under pressure from the right, such a high-profile project which focuses international attention on Jerusalem.
In return for Mr Arafat limiting his reaction to rhetoric, Mr Netanyahu is reported to have agreed to a more substantial Israeli redeployment on the West Bank next month under the Hebron agreement than had originally been planned.
There are signs that Mr Arafat does not want a confrontation. At the village of Hisma, to the north of Jerusalem, where a Palestinian man was shot dead by an Israeli undercover squad on Tuesday, the Palestinian Preventive Security Service co-operated with Israeli forces in imposing a curfew.