Israel says it will speed up Jewish settlement construction in the West Bank and East Jerusalem - and freeze the transfer of funds to the Palestinian Authority.
The announcement comes a day after the Palestinians won full membership of the UN cultural organisation, Unesco.
Palestinian President Mahmoud Abbas says the move will speed up the destruction of the peace process.
The Israeli government has called the Unesco vote a "tragedy".
The BBC's Kevin Connolly says the latest Israeli announcement is a blunt political statement, but doesn't come as a surprise.
He says it will be seen as a punishment for the Palestinians and a warning to the countries that backed their Unesco bid that Israel will react more strongly still if a similar application for Palestinian membership of the UN itself should prove successful.
BBC News
The USA and Canada have cut contributions to UNESCO because Palestinians joined. Self-determination is a core principle of international law- but since when have the Americans or Israelis respected international law? Tzipi Livni, a war criminal and daughter of a notorious terrorist, admitted recently that she was against international law.
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