Israel has rejected calls by the US to suspend a planned housing project in East Jerusalem, positioning the two allies for a potential standoff over settlement construction.

Israeli officials said on Sunday that Michael Oren, the country's ambassador to Washington, had been summoned to the state department and told that a project in the disputed section of the holy city should be abandoned.

According to the Israeli Army Radio, the US has demanded that planning approval for the project, which is being developed by an American millionaire, be revoked.

But Binyamin Netanyahu, the Israeli prime minister, rejected the US demands, telling a cabinet meeting on Sunday that there would be no limits on Jewish construction anywhere in "unified Jerusalem".

"We cannot accept the fact that Jews wouldn't be entitled to live and buy anywhere in Jerusalem," Netanyahu declared, calling Israeli sovereignty over the entire city "indisputable".