Israel's ambassador to the US has said that relations between the two countries are at their lowest point for 35 years, Israeli media have reported.Last week Israeli officials announced the building of 1,600 new homes in occupied East Jerusalem while US Vice-President Joe Biden was visiting.
The move was seen as an insult to the US. Palestinian leaders say indirect talks with Israel are now "doubtful".
But Israel's PM said Jewish settlements did "not hurt" Arabs in East Jerusalem.
Addressing Israel's parliament, the Knesset, Benjamin Netanyahu said he wanted peace negotiations, and hoped the Palestinians would not present "new preconditions" for talks.
"No government in the past 40 years has limited construction in neighbourhoods of Jerusalem," he said.
"Building these Jewish neighbourhoods in Jerusalem does not hurt the Arabs of East Jerusalem or come at their expense."
Meanwhile, EU foreign policy head Baroness Ashton, who is on a Middle East tour, said Israel's decision had put the prospect of indirect talks with the Palestinians in jeopardy.
'Difficult period'
Previously the Israeli government had played down the strain in relations with the US.
But Israel's ambassador to the US, Michael Oren, told a conference call with Israeli consuls general in the US that "the crisis was very serious and we are facing a very difficult period in relations", the Israeli media reported on Monday.
On Friday, Mr Oren was summoned to the state department and was reprimanded about the affair, the Israeli Ynet News website reported.
Ynet quoted the ambassador as saying "Israel's ties with the US are in the most serious crisis since 1975".
In 1975, US-Israeli relations were strained by a demand from then US Secretary of State Henry Kissinger that Israel's Prime Minister Yitzhak Rabin partially withdraw its troops from the Sinai Peninsula, where they had been since the 1967 Six-Day War.
The Haaretz newspaper said the ambassador's quote had been reported to it by four of the Israeli consuls general following the conference call on Saturday.
Mr Oren had appeared "tense and pessimistic", the consuls general told the newspaper.
They were instructed to lobby members of congress and Jewish community leaders and tell them Israel had not intended to cause offence.
"These instructions come from the highest level in Jerusalem," Haaretz quoted Mr Oren as saying.
The Israeli embassy in Washington has not yet commented publicly on the story.
The EU, as part of the Middle East Quartet, has already condemned Israel's decision to build new homes in East Jerusalem.
Speaking to members of the Arab League in Cairo on Monday, Lady Ashton said the move had "endangered and undermined the tentative agreement to begin proximity talks".
She added: "The EU position on settlements is clear. Settlements are illegal, constitute an obstacle to peace and threaten to make a two state-solution impossible."
'Insult'
On Sunday, a top aide to US President Barack Obama said Israel's announcement of plans to build 1,600 homes for Jews in East Jerusalem was "destructive" to peace efforts.
David Axelrod said the move, which overshadowed Mr Biden's visit to Israel, was also an "insult" to the United States.
Just hours before the announcement Mr Biden had emphasised how close relations were, saying there was "no space" between Israel and the US.
Mr Netanyahu has tried to play down the unusually bitter diplomatic row between the two allies.
He said the announcement was a "bureaucratic mix-up" and that he "deeply regretted" its timing.
Under the Israeli plans, the new homes will be built in Ramat Shlomo in East Jerusalem.
The Palestinians are threatening to boycott newly agreed, indirect talks unless the Ramat Shlomo project is cancelled.
Close to 500,000 Jews live in more than 100 settlements built since Israel's 1967 occupation of the West Bank and East Jerusalem. The settlements are considered illegal under international law, although Israel disputes this.
