EU envoys in the Middle East are urging Brussels to treat East Jerusalem as the future capital of a Palestinian state.
The recommendation comes in a leaked report by the heads of 25 European missions in Jerusalem and Ramallah.
The report also calls for an EU presence at the demolitions of Palestinian homes, and intervention when peaceful protesters face arrest.
The document follows the razing of an East Jerusalem hotel to make way for 20 homes for Jewish settlers.
The destruction of the Shepherd Hotel has angered Palestinians, who want East Jerusalem as the capital of their future state.
The US and the EU have strongly condemned the demolition, which is against international law, but Israel says it has a right to build homes in any part of the city.
The confidential policy document, prepared last month by the EU consuls-general, warns that Jewish settlement activity on occupied Palestinian land is making a two-state solution to the conflict increasingly difficult.
"The continued expansion of settlements, restrictive zoning and planning [and] ongoing demolitions and evictions... have not only serious humanitarian consequences, they undermine the Palestinian presence in East Jerusalem," the report says.
The diplomats recommend "specific actions" to bring EU actions in the occupied territory in line with the bloc's stated policy on East Jerusalem. The recommendations include:
EU officials have not publicly commented on the leaked report, which was drawn-up for the EU's main foreign policy-making body. It is unclear if or when the recommendations will be adopted or implemented.
European criticism of Israeli policy and settlements on occupied Palestinian land is not new, says the BBC's Wyre Davies in Jerusalem.
But with a conclusion that Israel was "systematically undermining the Palestinian presence" in Jerusalem, the policy document could further strain relationships between Israel and the EU, our correspondent adds.
The document was leaked hours after Israeli bulldozers cleared the way for 20 new homes for Jewish settlers in Sheikh Jarrah - a predominantly Arab neighbourhood of East Jerusalem - by demolishing the derelict Shepherd Hotel on Sunday.
The move was criticised by the EU and by US Secretary of State Hillary Clinton, who called it a "disturbing development [that] undermines peace efforts to achieve the two-state solution".
But Israeli Prime Minister Benjamin Netanyahu defended the demolition on Monday, saying it was a private real estate deal, and insisted that Jews had the right to live anywhere in Jerusalem.
"Actions undertaken yesterday at the Shepherd Hotel were conducted by a private individual in accordance with Israeli law," the statement from Mr Netanyahu's office said.
Attempts by US President Barack Obama to revive peace negotiations stalled late last year, after Israel refused to end settlement building on occupied Palestinian land.
Nearly 500,000 Jews live in more than 100 settlements built since Israel's 1967 occupation of the West Bank and East Jerusalem.
Israel annexed East Jerusalem in 1981 and sees it as its exclusive domain. Under international law the area is occupied territory.