New EU guidelines barring its 28 members from funding projects in Jewish settlements mean Israel must move towards resuming peace talks instead of stalling, or risk international isolation, officials and commentators say.

The guidelines forbid dealing with or funding Israeli entities that lie outside Israel proper and beyond the so-called 1967 Green Line -- that is, in the West Bank and east Jerusalem, Gaza and the Golan Heights.

They also require any future signed agreements to recognise that these areas are not part of the Jewish state.

This creates a dilemma for Israel over whether to continue occupying the West Bank and risk damaging its relations with the international community -- not to mention its trade prospects -- or to comply fully.

And compliance would by default mean a move towards negotiating a peace with the Palestinians, commentators and officials said on Wednesday.

Justice minister and chief peace negotiator Tzipi Livni, who warned earlier this month that the European Union would begin boycotting Israel if there was no progress on peace efforts, said the guidelines were a clear warning.

"The policy of stagnation on the Palestinian issue is creating a void the international community is trying to fill," she told public radio.

"I hope this constitutes a warning signal that will lead to a resumption of negotiations with the Palestinians."

Opposition and Labour party leader Shelly Yachimovich told public radio Israel faced "international isolation" by trying to maintain the status quo on the Palestinian issue.

And the effects of the new guidelines, which are to be implemented from January 2014, could include the loss of hundreds of millions of euros (dollars) for Israel, media said.

Haaretz newspaper said the "moment of truth" was approaching for Israel's peace talks policy.

"Israel's government needs to decide if it is ready to continue to endanger the country's future for the sake of continuing the occupation," it warned.

Prime Minister Benjamin Netanyahu rejected what he called "external dictates on our borders."

He also said the Europeans appeared to have a distorted sense of priorities, saying in a statement that the settlement and Palestinian issues were not as urgent as "the Syrian civil war or Iran's race to obtain nuclear weapons."

Many in the cabinet also railed against the EU guidelines, with ministers in Netanyahu's Likud party saying the initiative would undermine efforts by US Secretary of State John Kerry to bring about a resumption of peace talks, which have stalled since 2010.

"Nothing good will come of this decision, certainly not regarding talks with the Palestinians, who will use it as a pretext not to come to the negotiating table," said Communications Minister Gilan Erdan.

"It's a decision void of any logic whilst Kerry tries to restart talks," he told public radio.

But Yediot Aharonot newspaper insisted, in a Wednesday editorial, that Netanyahu must move to resume peace talks, and stop stalling.

"The tangle that is now coming to light with Europe requires Netanyahu to make decisions of historic dimensions," it said.

The Palestinians, meanwhile, have welcomed the guidelines, with both foreign minister Riyad al-Malki and Gaza rulers Hamas on Wednesday praising the EU decision.

"This hugely helps the Palestinians and their position. It is a very important message for us... we welcome this step," Malki said in a newspaper interview.

And an official Hamas statement praised the decision, saying it is "a step in the right direction and pressures the occupation."