Steffen Seibert, Merkel's spokesman, said Germany took a "very negative view" of the settlement announcement, which he said undermined peace efforts.
The growth of settlements, now home to half a million Israelis, is at the heart of the four-year breakdown in negotiations.
The Palestinians view continued settlement expansion as a show of bad faith and refuse to return to talks unless construction is frozen. Netanyahu notes a 10-month settlement slowdown in 2010 failed to jump-start negotiations, and rejects calls for a new construction freeze.
The U.N. General Assembly voted overwhelmingly on Thursday to recognize a Palestinian state in the West Bank, east Jerusalem and the Gaza Strip, territories Israel captured in the 1967 Mideast war. Israel still occupies those first two territories and restricts access to Gaza, though it withdrew all settlers and soldiers in 2005.
Netanyahu rejects a return to Israel's 1967 lines. His government campaigned against the U.N. measure, saying only direct negotiations could produce a Palestinian state.
But in a stinging diplomatic defeat, just eight other countries, including the U.S., opposed the Palestinian bid. Israel's closest allies in Europe, including Germany, Italy, France and Britain, either abstained or voted with the Palestinians in what amounted to a sweeping condemnation of Israeli settlements.
Israel retaliated by announcing the next day that it would start drawing up plans to build 3,000 settlement homes in the West Bank and east Jerusalem. More explosively, from the Palestinian point of view, it said it would begin planning work for a chunk of land east of Jerusalem known as E1.
Building there would sever the link between the West Bank and east Jerusalem, which the Palestinians claim for a future capital. It would also cut off the northern part of the West Bank from its southern flank.
The Palestinians say construction in that territory would kill any hope for establishing a viable state of Palestine. Successive U.S. governments have agreed, and under intense American pressure, Israel has avoided building settlements in the area. It has, however, developed roads and infrastructure and built a police station.
On Wednesday, Israel's planning and construction committee for the area is scheduled to hold a first-ever meeting to discuss developing the E1 area, a defense official said.
The session, described by the official as a "very, very preliminary" step, would be open to Jewish politicians in the West Bank and developers, as well as Palestinians with any claims to parts of the land. This would be the first step in a planning process that could take months, if not years, before ground is actually broken.
The official spoke on condition of anonymity because he was not authorized to discuss the project.
Actual settlement construction remains far from certain and may have been announced by Netanyahu to appeal to hawkish voters ahead of Israel's Jan. 22 election.
Hinnant reported from Paris. Jill Lawless in London, Louise Nordstrom in Stockholm, Sweden, David Rising in Berlin, Ciaran Giles in Madrid, and Dalia Nammari in Ramallah, West Bank, contributed to this report.
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