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For many Israelis, the decision was especially tough by grouping east Jerusalem with the West Bank. Israel annexed the area after the 1967 war and most Israelis, even those on the dovish left, consider it somehow distinct from the settlements and do not view its Jewish residents as settlers.
The decision puts Israel in a difficult situation: appear to agree that the occupied territories, including east Jerusalem and the annexed Golan Heights, are not part of Israel, or risk losing funding and collaboration opportunities provided by these EU programs.
Direct commercial ties are not affected by the order. But Europe, Israel's largest trade partner, also has begun to take action in that area.
The 28-member EU already bars goods produced in Israeli settlements from receiving customs exemptions given to Israeli goods. EU officials are currently considering measures that would more clearly label settlement goods.
Palestinian official Hanan Ashrawi welcomed the decision.
"The EU has moved from the level of statements, declarations and denunciations to effective policy decisions and concrete steps," she said. "The Israeli occupation must be held to account."
European officials tried to play down the significance of the measures. "This is not new. It's more of a clarification," said EU spokeswoman Maja Kocijancic. European officials estimated that less than 1 percent of funding actually goes to "settlement entities."
Nonetheless, Israeli officials reacted with great alarm and claimed the decision would undermine Kerry's efforts by encouraging the Palestinians to harden their positions.
Israeli Deputy Foreign Minister Zeev Elkin, one of the participants in the meeting with Netanyahu, called the EU decision a "very significant and worrying move" that would embolden the Palestinians in their "refusal to return to the negotiation table."
Other participants included chief peace negotiator Tzipi Livni, a relative dove who recently warned that Europe's shunning of the settlements could eventually lead to a wider boycott of Israeli goods if peace efforts do not resume.
Dani Dayan, an official with the Israeli settler movement Yesha, called the decision "one-sided and discriminatory" and said "the EU can no longer be perceived as neutral or objective."
Raffaella Del Sarto, who teaches at the European University Institute and SAIS Europe, Johns Hopkins University, said Israel appeared to be caught off guard by the EU's tough stance. "The EU is generally pretty good at declaring and not acting, and here we have the opposite development," she said. "Some would say that Israel is finding itself in growing isolation."
Earlier this week, a leftist Israeli newspaper columnist, Gideon Levy, crossed something of a rubicon in calling for an international boycott of Israel.
"As long as Israelis don't pay a price for the occupation ... they have no incentive to bring it to an end," he said.
Such a view is hardly mainstream, but it is also increasingly heard among Israelis who are despairing of a solution and who fear that the settlements will undermine Israel itself by making partition impossible and yielding, in effect, a bi-national state.