"The EU expresses deep concern about developments on the ground which threaten to make a two-state solution impossible," the bloc's 27 ministers said in a statement issued during talks in Brussels.
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"The viability of a two-state solution must be maintained," the three-page European Union statement added.
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 and incitement 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."
The ministers' stand came on the heels of a damaging report by NGOs 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 issued a statement saying 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."
"Such a public presentation does not contribute to advancing the (peace) process," it said.
"Israel is committed to the wellbeing of the Palestinian population and acts according to all relevant international conventions."
In contrast, 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. "What is lacking, unfortunately, is a mechanism to move ahead... We were hoping that they would take an initiative, a mechanism, concrete steps."
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