Israel will not transfer tax revenue collected to the Palestinian Authority as punishment for its bid to join some 15 international organizations and treaties.
The move came amid reports of a breakthrough in the crisis currently threatening to derail peace talks.
An Israeli official told Ynet that the economic sanctions came in response to the Palestinians' UN move. According to him Israel will deduct the PA's financial debts from the taxes Israel collects in its name. Israel will also halt the development of gas fields across the shores of the Gaza Strip.
An Israeli diplomatic official criticized the move and said "the prime minister cannot control himself, he feels a relentless need to punish the Palestinians. At a time like this we should move forward and not get stuck up on the UN petition."
The Palestinians owe Israeli companies hundreds of millions of dollars for electricity, power and other services. The Israeli official, speaking on condition of anonymity, said Israel would deduct the debt against its monthly transfer of tax money is collects for the Palestinians.
That money is some $100 million a month. It wasn't clear how much money would be withheld.
Under interim peace accords, Israel collects taxes on behalf of the Palestinians. Without it, the Palestinian Authority can't pay its workers.
An unnamed source told Al Arabiya early Thursday that a deal has been reached to extend peace talks, but all three parties have since downplayed the claim as premature, but the US did say "gaps were narrowing" in talks.
According to the Al Arabiya report, the deal will see a number of Palestinian prisoners freed and a freeze on West Bank settlement construction. In return, the Palestinians will suspend their plans to join 15 international bodies.
To sweeten the deal for Israel, the source claimed the US has promised to release jailed US-Israeli spy Jonathan Pollard.
State Department Spokeswomen Jen Psaki said the reports about the deal were "inaccurate" but noted that "our negotiating team and both parties remain in intensive negotiation. They had another meeting today. The gaps are narrowing but any speculations about an agreement are premature at this time."
A Palestinian source said talks were still in crisis and that no breakthrough had yet been made, despite US efforts. The source also noted that no deal securing the release of Palestinian prisoners in return for Pollard had yet been reached.
A senior Israeli official also said that "no breakthrough has been attained, the gaps are still large and disagreements still exist about the outline of reaching any agreements on extending talks."
Wednesday Israeli government officials said Netanyahu had ordered cabinet members, directors-general of government ministries and other senior officials not to meet their counterparts in the Palestinian Authority.
It was reported that Israel was "serious considering" deducting up to $75 million in tax revenue transfers to the Palestinians, the Israeli official said.
Citing Palestinian figures, Israel estimates this is the sum of annual Palestinian aid provided to their prisoners in Israeli jails convicted of violence, including lethal attacks.
Under 1990s interim peace deals, Israel collects and transfers to the PA some $100 million a month in taxes on goods imported into the Palestinian territories. Israel has previously frozen the payments during times of heightened tension.
Palestinian officials said Palestinian President Mahmoud Abbas had signed the international agreements, including the Geneva Conventions covering the conduct of war and occupation, in response to Israel's failure to carry out a promised release of several dozen Palestinian prisoners a few days earlier.
Palestinians were further angered by the subsequent April 1 announcement on settlements.
At a cabinet session on Sunday, Netanyahu pledged to retaliate for Abbas's move, which Israel sees as a unilateral step toward statehood and an attempt to gain leverage over it.
Israel had conditioned freedom for the fourth and last group of the 104 prisoners it had pledged to release, when peace talks restarted last July, on a Palestinian commitment to extend the negotiations beyond April.
It said the tender to build new houses in East Jerusalem, had been issued last year and was resubmitted because there had been no initial takers.
Yitzhak Benhorin, Elior Levy the Associated Press and Reuters contributed to this report