Israel has blocked the European Union from aiding tens of thousands of Palestinians in the West Bank, in retaliation for an EU ban on financial assistance to Israeli organizations in the territories.
The EU imposed its restrictions last week, citing its frustration over the continued expansion of Jewish settlements in territory captured by Israeli forces in the 1967 Middle East War. The new guidelines render Israeli entities operating there ineligible for EU grants, prizes or loans, beginning next year.
An Israeli official said on Friday the Jewish state was compelled to respond to the EU's decision "to sanction or boycott the settlements".
"From our standpoint we cannot just ignore this or treat spitting in our face as though it is rain," the official said.
Settler leaders say the aid they receive from Europe is minimal. But many in Israel worry about knock-on effects the EU steps may have on individuals or companies based in Israel that might be involved in business in the settlements, deemed illegal by the international community.
The Israeli official, speaking on condition of anonymity, said Defense Minister Moshe Yaalon had decided to suspend contacts with the EU in the West Bank.
Yaalon, a former army chief and a hardliner in Prime Minister Benjamin Netanyahu's Likud party, has "frozen projects, canceled meetings, curtailed coordination and permits for Europe's operations" for Palestinians living in what is known as Area C, a West Bank area fully administered by Israel, he said.
In Brussels, Maja Kocijancic, spokeswoman for EU foreign policy chief Catherine Ashton, said: "The EU is concerned by reports in the Israeli media that the Israeli Minister of Defense has announced a number of restrictions affecting EU activities supporting the Palestinian people.
"We have not received any official communication from the Israeli authorities. Our delegations on the spot are seeking urgent clarifications," Kocijancic added.
A Western diplomat, speaking on condition of anonymity, said that due to the Israeli measures, several European humanitarian aid staff had failed to receive permits to enter the Palestinian-ruled Gaza Strip.
Under the terms of a 1993 interim peace accord, some 150,000 Palestinians, many of them poor farmers and shepherds living in Area C, a West Bank zone where many settlements have been built, are fully under Israeli military control,
The Palestinians have limited self-rule over other parts of the West Bank, and share joint custody with Israel over yet other areas.
Some of Europe's assistance in the West Bank goes to Palestinians for building homes. But many have been designated illegal and demolished by Israel.
The Association of International Development Agencies, a coalition of 80 aid groups, said in a report in May that 600 settler houses had been built since mid-2012, while Israel demolished 535 Palestinian-owned homes and structures.
The United States, Israel's main backer, has been trying to revive peace talks that have been deadlocked for three years and are aimed at reaching an agreement for the Palestinians to establish a state alongside Israel.
Additional reporting by Justyna Pawlak in Brussels; Writing by Allyn Fisher-Ilan; Editing by Mark Trevelyan