Israel has withheld part of its $75m (£38m) monthly tax revenue payment to the Palestinian Authority after a diplomatic offensive by the Prime Minister, Salam Fayyad, designed to stop the continued expansion of Jewish settlements.
The move appeared to mark a new low in relations between Israel and a moderate Palestinian leadership increasingly disillusioned by the lack of progress in talks with Ehud Olmert's government.
Israel has accused Mr Fayyad, who is widely respected by Western governments, of trying to "undermine" its relations with Europe. The Palestinian Prime Minister has written to all EU prime ministers urging them to shelve plans to upgrade the EU's relationship with Israel until it ceases to "flout its international obligations", including those on settlement construction in East Jerusalem and the West Bank.
Israeli officials expressed deep "regret and disappointment that our Palestinian interlocutors with whom we are working for a common goal – especially Prime Minister Fayyad – are spending time and energy to undermine Israel's bilateral relations with the EU".
The EU, whose foreign ministers will discuss the issue at a meeting in Luxembourg on 16 June, is already split over whether to deepen technical and political ties with Israel. Israel is seeking a series of new joint technical committees and regular high-level political meetings with the EU.
The Israeli Finance Minister, Roni Bar-On, initially withheld the full monthly payment owed to the Authority after Mr Fayyad also wrote in similar terms to the Paris-based Organisation of Economic Co-operation and Development urging it to suspend current negotiations on Israel's application for full membership.
Yesterday Mr Bar-On relented by agreeing to transfer a large portion of the money tomorrow. Israel says the remainder that it is withholding is part of a $50m debt owed by the Palestinians for electricity supply, but it had not made such a deduction before and Israeli sources did not deny that it relates to Mr Fayyad's approach to the OECD.
This week, the Palestin-ian President, Mahmoud Abbas, called for a "national dialogue" with Hamas. Western officials see the move as a significant overture despite declarations by his aides that he was still insisting on Hamas ceding the absolute control of Gaza it seized in June last year.
One theory was that having been persuaded not to attempt a reconciliation with Hamas because he would lose the fruits of any negotiations with Israel, Mr Abbas was beginning to think that the progress of talks so far made that an empty threat.
The Israeli Housing Ministry has confirmed that despite complaints by the US, EU and the UN, it plans 884 more housing units in East Jerusalem settlements.
According to reports of Mr Fayyad's letter to the EU prime ministers he says "Now – more than ever – is the time for the EU to act on the principled position that it reaffirmed again .. that Israeli settlement activity anywhere in the [occupied territories], including East Jerusalem, is illegal" and "threatens the viability of an agreed two-state solution".
Mr Fayyad, who also condemns Israel's failure to implement the 2004 advisory opinion of the International Court of Justice that the route of the separation barrier through parts of the West Bank was illegal, says an unconditional EU upgrade would be seen as rewarding "unlawful behaviour".
The monthly payments of tax revenues that Israel collects on behalf of the PA were witheld for more than a year after Hamas won legislative elections in 2006 but reinstated after Mr Abbas installed an emergency government under Mr Fayyad when Hamas seized full control in Gaza.
And renewed warnings of a possible large-scale military invasion of Gaza further threaten the faltering negotiations between Mr Abbas and Mr Olmert. Yesterday, a Palestinian militant was killed and an Israeli soldier wounded in a exchange of fire at the Gaza border.