In an unusually frank insight into British assessments of Israeli intentions, the document says that Ariel Sharon's government is jeopardising the prospect of a peace agreement by trying to put the future of Arab East Jerusalem beyond negotiation and risks driving Palestinians living in the city into radical groups. The document, obtained by the Guardian, was presented to an EU council of ministers meeting chaired by the foreign secretary, Jack Straw, on Monday with recommendations to counter the Israeli policy, including recognition of Palestinian political activities in East Jerusalem.

But the council put the issue on hold until next month under pressure from Italy, according to sources, which Israel considers its most reliable EU ally.

Israel has described a recommendation for moving EU meetings with the Palestinian Authority from Ramallah to East Jerusalem in recognition of the Arab claim as "negative occurrence". It claims the eastern part of Jerusalem it occupied in the 1967 war is part of its "indivisible capital". Almost all governments maintain embassies in Tel Aviv because they do not recognise the Israeli claim.

The document, drawn up by the British consulate in East Jerusalem as part of the UK's presidency of the EU, says Israeli policies are designed to prevent Jerusalem from becoming a Palestinian capital, particularly settlement expansion in and around the city. It says Mr Sharon's plan to link Jerusalem with the large Ma'ale Adumim settlement in the West Bank by building thousands of new homes "threatens to complete the encircling of the city by Jewish settlements, dividing the West Bank into two separate geographical areas".

It adds: "Israeli activities in Jerusalem are in violation of both its Roadmap (peace plan) obligations and international law."

The Foreign Office also concludes that the vast concrete barrier, which Israel asserts is a security measure, is being used to expropriate Arab land in and around the city. "This de facto annexation of Palestinian land will be irreversible without very large-scale forced evacuations of settlers and the re-routing of the barrier."

The document says stringent Israeli controls on the movement of Palestinians in and out of the city are an attempt to restrict Arab population growth. "When the barrier is completed, Israel will control all access to East Jerusalem, cutting off its Palestinian satellite cities of Bethlehem and Ramallah, and the West Bank beyond. This will have serious ... consequences for the Palestinians," it says.

"Israel's main motivation is almost certainly demographic ... the Jerusalem master plan has an explicit goal to keep the proportion of Palestinian Jerusalemites at no more than 30% of the total." All of this, the document says, greatly reduces the prospects of a two-state solution because a core demand of the Palestinians is for sovereignty over the east of the city.

"Palestinians are deeply alarmed about East Jerusalem," the document says. "They fear that Israel will 'get away with it', under the cover of disengagement. Israeli measures also risk radicalising the hitherto relatively quiescent Palestinian population of East Jerusalem."