The resolution was adopted after the United States abstained, allowing the measure to pass by a vote of 14 in favour in the 15-member council.
"The Security Council decision is a big blow for Israeli policies," said Palestinian presidency spokesman Abu Rudeina.
The move was "an international and unanimous condemnation of settlements and strong support for the two-state solution," he told AFP.
Saeb Erakat, a former peace negotiator and the number two in the Palestine Liberation Organisation (PLO), spoke of a "historic day".
"December 23 is a historic day and a victory for international legitimacy, international law and international documents," said Erakat.
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The vote was a "clear and unanimous message to (Israeli Prime Minister Benjamin) Netanyahu that 'your policies will not achieve peace and security for Israel or the region”.
"The only way to peace is through the creation of an independent Palestinian state, and this is what the international community agreed upon today at the Security Council," he added.
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Israel's envoy to the United Nations, Danny Danon, said in New York that his government had expected its US ally to veto "this disgraceful resolution."
Before the vote an Israeli official, who spoke in Jerusalem on condition of anonymity, had said that US President Barack Obama and Secretary of State John Kerry were "behind this shameful move against Israel at the UN".
The resolution demands that "Israel immediately and completely cease all settlement activities in the occupied Palestinian territory, including East Jerusalem."
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It states that Israeli settlements have "no legal validity" and are "dangerously imperilling the viability of the two-state solution" that would see an independent Palestine co-exist alongside Israel.
Israeli settlements are seen as a major stumbling block to peace efforts, as they are built on land that the Palestinians see as part of their future state.
The United Nations maintains that settlements are illegal, but UN officials have reported a surge in construction.
Some 430,000 Israeli settlers currently live in the occupied West Bank and another 200,000 in annexed east Jerusalem, which the Palestinians see as the capital of their future state.
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