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US Vice-President Joe Biden is meeting the Palestinian Authority President, Mahmoud Abbas, in Ramallah.
The Israeli government's approval of plans for 1,600 more homes in a Jewish settlement in occupied East Jerusalem is expected to dominate the talks.
Mr Biden earlier said the substance and timing of the decision had undermined the trust needed for peace talks.
The Palestinian Authority said the move showed the Israelis believed US efforts had failed before they had even begun.
Both sides have agreed to hold indirect "proximity talks" in a bid to restart the peace process, which has been stalled for 17 months.
Mr Abbas has refused to resume direct negotiations with the Israeli government because of its refusal to put a complete stop to the expansion of settlements in the West Bank and East Jerusalem.
In November, Israel announced a 10-month suspension of new building in the West Bank, under heavy US pressure. But it considers areas within the Jerusalem municipality as its territory and the restrictions do not apply.
Close to 500,000 Jews live in more than 100 settlements built since Israel's 1967 occupation of the West Bank and East Jerusalem. They are considered illegal under international law, although Israel disputes this.
During their dinner on Tuesday evening, Israeli Prime Minister Benjamin Netanyahu told Mr Biden that he had no prior knowledge of the decision to authorise the new housing units in the ultra-Orthodox settlement of Ramat Shlomo, officials said.
He said the plans had been submitted three years ago and had only received initial approval that day.
"The district committees approve plans weekly without informing me," Interior Minister Eli Yishai, the chairman of the ultra-Orthodox Shas party, told Israel Radio on Wednesday morning.
"If I'd have known, I would have postponed the authorisation by a week or two since we had no intention of provoking anyone."
'Disastrous step'
But the US government has not accepted Israel's explanation that the announcement was essentially part of a bureaucratic process that had no connection with Mr Biden's visit, says BBC Middle East editor Jeremy Bowen in Jerusalem.
Israel, deliberately or not, inflicted something close to a humiliation on the Obama administration and the words they chose in reaction reflected that, our correspondent says.
"The substance and timing of the announcement, particularly with the launching of proximity talks, is precisely the kind of step that undermines the trust we need right now and runs counter to the constructive discussions that I've had here in Israel," Mr Biden said.
"We must build an atmosphere to support negotiations, not complicate them. This announcement underscores the need to get negotiations under way that can resolve all the outstanding issues of the conflict."
"Unilateral action taken by either party cannot prejudge the outcome of negotiations on permanent status issues," he added.
Palestinian Prime Minister Salam Fayyad said he appreciated "the strong statement of condemnation" by the US about the "damaging" Israeli announcement.
The chief Palestinian negotiator, Saeb Erekat, said the Ramat Shlomo plans would dominate the meeting between Mr Biden and Mr Abbas.
"This is a disastrous step on behalf of the Israelis - it is catastrophic," he told the BBC. "The only message we are getting from the Israelis is their determination to undermine the American efforts and to undermine these negotiations before they even begin."
"But we hope that the Americans will move another step in the direction of having the Israelis revoke this order, if they want to give the process the chance it deserves."
The Arab League will meet in Cairo later to decide on a response.
Just hours before Mr Biden's arrival on Monday, the Israeli defence ministry infuriated the Palestinian Authority by approving the construction of 112 new housing units in the West Bank settlement of Beitar Illit.
It said the units had been approved before the start of the 10-month moratorium, and that they were an "exception", because of safety and infrastructure issues.
Israeli government spokesman Mark Regev said on Wednesday that it had gone further than any previous administration in limiting settlement growth in an effort to restart the peace process.
He rejected claims that it had damaged relations with the US.
"We have a very good working relationship and a very good personal relationship," he told the BBC.
Mr Regev also dismissed speculation that the interior ministry's announcement was a deliberate move by some members of Mr Netanyahu's cabinet to scupper any chance of peace talks.
"I don't think so. We are hopeful now that we are entering a new period of negotiations, that we hope will lead very quickly to the resumption of direct talks," he added.
Our correspondent says the Americans will have to work hard to keep the Palestinians in the peace talks they are trying to launch - that may have been one reason for the strong language Mr Biden used.
This row is another reminder of why so many people are pessimistic about peace talks - and deeply worried about the future, he adds.
The US special envoy to the Middle East, George Mitchell, is scheduled to arrive in the region next week to conduct the second round of proximity talks. -BBC
