An official, who declined to be named, said the government had also decided to expedite planning work for thousands more homes in a geographically sensitive area close to Jerusalem that critics say would kill off Palestinian hopes of a viable state.
The decision was made on Thursday when it became clear that the U.N. General Assembly was set to upgrade the Palestinians' status in the world body, making them a "non-member state", as opposed to an "entity", boosting their diplomatic clout.
The motion was backed by 138 nations, opposed by nine, while 41 members abstained - a resounding defeat that exposed its growing diplomatic isolation.
An Israeli official had earlier conceded that this represented a "total failure of diplomacy" and warned there would be consequences - which were swift in coming.
Plans to put up thousands of new settler homes in the wake of the Palestinian upgrade were always likely, but the prospect of building in an area known as E-1, which lies near Jerusalem and bisects much of the West Bank, is seen by some as a potential game changer.
"E-1 will signal the end of the two state-solution," said Daniel Seidemann, an Israeli expert on settlements. He added that statutory planning would take another six to nine months to complete, meaning building there was not a foregone conclusion.
About 500,000 Israelis already live in the West Bank and East Jerusalem on land Israel seized in the 1967 Middle East war - territory the Palestinians claim for their independent state.
The United States, one of the eight countries to vote alongside Israel at the U.N. General Assembly, said the latest expansion plan was counterproductive to the resumption of direct Israeli-Palestinian peace talks.
Ahead of the U.N. vote, Prime Minister Benjamin Netanyahu's government had argued that the unilateral Palestinian move breached their previous accords and accused the 193-member world body of failing in its responsibilities.
"The General Assembly can resemble the theatre of the absurd, which once a year automatically approves ludicrous, anti-Israeli resolutions," said government spokesman Mark Regev.
"Sometimes these are supported by Europe, sometimes they are not," he added, alluding to the fact that only one European state, the Czech Republic, had voted against the Palestinians.
Nonetheless, analysts said the vote exposed the gulf that had opened between Europe and Netanyahu over his handling of the Western-backed administration of Palestinian President Mahmoud Abbas, and the depth of EU opposition to settlement expansion.
"The government has failed to appreciate the gravity of the challenge to Israel's fundamental legitimacy in Europe," said Gidi Grinstein, head of the Reut Institute think-tank.
"The Palestinian bid in the U.N. is turning out to be a bigger defeat than anticipated."
In many ways, Israel was caught off guard.
Last week it was fighting Islamist militants in the Gaza Strip, grateful to see much of the West offering support for its determination to stop indiscriminate rocket fire from the Palestinian enclave whose leaders preach Israel's destruction.
The eight-day bombardment ended in a truce that was widely viewed as handing Gaza's Hamas Islamists a PR boost at the expense of Abbas and the Palestine Liberation Organisation, who have renounced violence in favour of diplomacy.
The West pumped billions into Abbas's administration over the years to bolster a partner for Middle East peace and felt they had to rally to his support in New York. Before the Gaza conflict, the Palestinians said they would win 115 'yes' votes at the United Nations. They ended up with more.
By itself, the U.N. upgrade will make little practical difference to the Palestinians or Israelis. However, the new position will enable Abbas to seek membership of the International Criminal Court (ICC) in the Hague if he wants.
This is what worries Israel.
The Geneva Convention forbids occupying powers from moving "parts of its own civilian population into the territory it occupies", leaving Israeli officials potentially vulnerable to an ICC challenge. Israel says its settlements are legal, citing historical and Biblical ties to the West Bank and Jerusalem.
The Palestinians say they are in no rush to go to the ICC, but the threat is there, putting pressure on Israel to come up with creative solutions to overcome the peace-talks impasse, which the Jewish state blames on Abbas.
"This U.N. vote is a very strong signal to the Israelis that they can't shove this matter under the carpet for any longer," said Alon Liel, former director-general of the Israeli Foreign Ministry. "This is a red light for Israel."
With politicians campaigning ahead of a Jan. 22 election, Israel is unlikely to change course.
Opinion polls suggest Netanyahu's right-wing bloc will win a new term in office. The coalition includes pro-settler parties, and the prime minister's own Likud group appeared to shift to the right in primaries this week, making any land-for-peace compromise with the Palestinians look more complex than ever.
His opponents seized on the U.N. vote, with ex-foreign minister Tzipi Livni, aspiring to become Israel's second female prime minister, blaming a failure of initiative.
"When we do not initiate, we are imposed upon," she said.
Israeli officials say the Palestinians themselves must show they are ready to make the sort of concessions that they believe are needed to secure an accord - such as renouncing any right to return to modern-day Israel for refugees and their descendants.
However, analysts say that with the elections out of the way, the new government will have a period of calm to try once more to end their decades-old conflict with the Palestinians.
"The strategy toward the Palestinian Authority and statehood is likely to be on the top of the agenda of the next government in the winter," said the Reut Institute's Grinstein.
"The outcome of its strategic reassessment may well be active engagement in upgrading the powers and responsibilities of the Palestinian Authority toward statehood, and eventually recognising the Palestinian Authority as a state."
If E-1 building goes ahead, the chances of talks resuming will be close to non-existent.