Israeli bulldozers have demolished part of a hotel in East Jerusalem 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 a future Palestinian state.
The Palestinian leadership said Israel was destroying any chance of returning to peace. The US called the demolition a "disturbing development".
Israel says it has a right to build homes in any part of the city.
The BBC reports the Shepherd Hotel was built in the 1930s and was once home to Amin al-Husseini, the Grand Mufti of Jerusalem who became an ally of Adolf Hitler in World War II.
Its current ownership is disputed - Israel says it belongs to a Jewish-American property developer but Palestinians say it was seized illegally after Israel occupied East Jerusalem in 1967.
A spokesman for Palestinian President Mahmoud Abbas said:
"Israel has no right to build in any part of East Jerusalem, or any part of the Palestinian land occupied in 1967."
Attempts by the United States to revive peace negotiations stalled last year, after Israel refused to end settlement building on occupied Palestinian land.
In a statement, Secretary of State Hillary Clinton said the demolition "undermines peace efforts to achieve the two state-solution".
"In particular, this move contradicts the logic of a reasonable and necessary agreement between the parties on the status of Jerusalem," she said.
Adnan al-Husseini, Palestinian governor of Jerusalem, said it was the latest in a line of demolitions of historic buildings and accused Israel of "trying to erase any Palestinian identity" from the city.
Occupied since 1967
Israeli officials said the demolition had been carried out legally.
The BBC reports nearly 500,000 Jews live in more than 100 settlements built since Israel's 1967 occupation of the West Bank and East Jerusalem.
The settlements are considered illegal under international law, although Israel disputes this.