New US President Donald Trump has taken a softer stance on Israeli settlement activity than his predecessor, Barack Obama, who was a vocal critic.
The new law comes amid an escalation in settlement activity in recent weeks.
Emboldened by what it sees as a more sympathetic US administration, Israel has advanced plans for thousands of new homes in settlements.
More than 600,000 Jews live in about 140 settlements built since Israel`s 1967 occupation of the West Bank and East Jerusalem - land the Palestinians claim for a future state. The settlements are considered illegal under international law, though Israel disputes this.
Palestinians say the new legislation negates peace and their chances of creating a state. However, its passage could be largely symbolic. Already Israel`s attorney general has said the law is unconstitutional and that he will not defend it in the Supreme Court.
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