"The EU expresses deep concern about developments on the grounds which threaten to make a two-state solution impossible," the bloc's 27 ministers said in a statement issued during talks in Brussels.
"The viability of a two-state solution must be maintained," the three-page European Union statement added.
Israeli settlement watchdog Peace Now said on Monday that Israel was moving ahead with plans to build around 2,000 new homes in the settlement of Gilo, in Israeli-annexed east Jerusalem.
"There was an announcement of depositing for public review, plans for 942 housing units with an option for 300 more," the group's Hagit Ofran told AFP. "The public now has 60 days to present objections."
"Next week, on May 22, there will be a discussion on objections to a different plan for Gilo, for 900 units," she added. "Another stage in the approvals process."
The Jerusalem Post daily said it could take years before all steps were complete and construction could begin.
Reiterating that settlements on occupied land are illegal under international law, the ministers notably condemned "the marked acceleration" of settlement building since the end of a 2010 moratorium and expressed "deep concern" over settler extremism in the West Bank.
They also voiced concern over evictions and the demolition of Palestinian homes in east Jerusalem "and the prevention of peaceful Palestinian cultural, economic, social or political activities".
Turning to the so-called Area C zone of the occupied West Bank, where Israel has full civil and security control, the statement noted "the worsening living conditions" of the Palestinian population in general.
The ministers' stand came on the heels of a damaging report by NGOs this weekend alleging that Israel last year demolished dozens of Palestinian homes, water cisterns and farm buildings built with European funds.
In Area C, Israel has placed "serious limitations" on the Palestinian Authority's ability to promote economic development, the statement said.
Saying the future of Area C was critical to a future Palestinian state because this was its main land reserve, the EU urged Israel to halt demolitions and simplify the granting of building permits.
"The EU will continue to provide financial assistance for Palestinian development in Area C and expects such investment to be protected for future use," the statement said.
But Israel's foreign ministry said the EU position included "a long list of claims and criticism which are based on a partial, biased and one-sided depiction of realities on the ground".
"Israel is committed to the wellbeing of the Palestinian population and acts according to all relevant international conventions," it said.
Hanan Ashrawi, a senior member of the Palestine Liberation Organisation, welcomed the EU statement as "politically responsible."
"We believe the EU statement is a very comprehensive and politically responsible statement. It addresses all the issues that have really brought about this crisis, including the settlement activity, and Israel's non-compliance with international law and UN resolutions," she told AFP.
But the Palestinians wanted to see the EU propose a way forward in stalled peace talks, which have been on hold since late September 2010, she said.
Leading charity Oxfam, which has been present on the ground for five decades, said it welcomed the "bold" EU stand.
"Oxfam witnesses daily the impact that Israeli settlement expansion, building restrictions and demolitions have on the Palestinian communities we work with," said Tidhar Wald, Oxfam's EU humanitarian policy advisor.
"Today's criticism is a first step towards helping these communities claim their basic rights."
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