The UN investigation, which was boycotted by the Jewish state, urged Israel to halt settlement construction unconditionally and begin removing all 500,000 Israeli settlers from occupied territory immediately.
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"This is incredible. We are extremely heartened by this principled and candid assessment of Israeli violations," said Hanan Ashrawi, a senior official in the Palestine Liberation Organization (PLO).
The UN report, issued in Geneva, said the settlements contravened the Fourth Geneva Convention forbidding the transfer of civilian populations into occupied territory and could amount to war crimes that fall under the jurisdiction of the International Criminal Court (ICC).
The Palestinians last year won a vote in the United Nations General Assembly granting them de facto statehood in territories Israel captured in the 1967 Middle East war.
The enhanced diplomatic status gives them access to many world bodies, including the ICC, and Palestinian leaders have said they might try to haul Israel before the court unless it halts the settlements and engages in meaningful negotiations.
"The report confirms and deepens the application of international law and shows that the law applies to all, and no one is above it," Palestinian government spokesperson Nour Odeh told Reuters.
Israel's foreign ministry condemned the report as "counterproductive and unfortunate," adding that the only way to resolve the dispute was through direct negotiations.
US-brokered talks between the two sides broke down in 2010 over the issue of settlement building. The Palestinians say they will not return to negotiations until the construction stops. Israel says there must be no preconditions.
Fatah, the party that holds sway over Palestinian-controlled areas of the West Bank, said on Thursday that Israeli rights violations were undermining the chances of peace.
"(Fatah) does not see any real opportunity for the resumption of the peace process and negotiations with the continued policy of settlement expansion, especially in Jerusalem, which would destroy the principle of a two-state solution," it said in a statement.
"It rejects dubious schemes to end the Palestinian cause through any temporary state, or other solutions which detract from the right of our people to self-determination. The rules of conflict have changed."
Israelis captured east Jerusalem in the 1967 war and later annexed the territory, proclaiming the city as their "eternal and indivisible" capital. Palestinians want to create the capital of their own state in the eastern half of Jerusalem.
Israel has called the Palestinian maneuvers in international bodies "diplomatic terrorism," while Palestinian President Mahmoud Abbas last week said a "legal, diplomatic war" in the UN arena was a fair option for his government.