Britain is considering withdrawing its ambassador to Israel over the country's settlement building plans, Sky sources say.
The Government is expected to decide later today how to respond to Israel's plan to allow settlement building in the controversial E1 area of East Jerusalem.
Sources have told Sky News that the Foreign Office is considering what action to take saying "all options are on the table".
This could include withdrawing the British ambassador to Israel and the suspension of trade agreements.
The Israeli Ambassador to London, Daniel Taub, was formally summoned to the Foreign Office this morning where the Minister for the Middle East, Alistair Burt, set out the UK's concerns.
Israel approved proposals to build 3,000 additional homes last week in a controversial plan that could effectively cut off Palestinians in East Jerusalem from the rest of the West Bank.
Britain's diplomatic threat come after the settlement plans were slammed by the head of the United Nations Ban Ki-moon as an "almost fatal blow" to peace hopes.
Sources have said there is "an appetite for action" within the Foreign Office, which could also take the form of "revisiting" the EU's trade agreements with Israel.
A Foreign Office spokesman said: "We deplore the recent Israeli government decision to build 3,000 new housing units and unfreeze development in the E1 block. This threatens the viability of the two state solution."
Ambassador Matthew Gould at the site of a rocket attack in Israel in 2011 He said: "Any decision about any other measure the UK might take will depend on the outcome of our discussions with the Israeli government and with international partners including the US and European Union."
Sam Kiley, Sky News' Middle East Correspondent, said: " What they are saying to Israel is that we are very angry about this, we are sincere we don't want to see any of these settlements continue to expand because, as Ban Ki-moon said yesterday, it will be a fatal blow to the peace process."
The UK could invoke human rights clauses in order to suspend the trade association agreements.
The E1 area of East Jerusalem is a 4.6 square mile area, which is largely uninhabited. Israel has been under pressure not to build homes there from the international community, especially the US.
This is because any settlement will effectively cut the West Bank in two and prevent a contiguous Palestinian state.
Israel has built 100 settlements since its occupation of East Jerusalem and the West Bank - development that is considered illegal under international law.
However, there was a moratorium on settlement building but this ended in 2010, bringing an end to peace talks between the Israelis and the Palestinians.
The announcement of the new settler homes prompted stern responses from both the US and Britain, traditionally close allies of Israel.
Mr Netanyahu approved the proposals to build the 3,000 homes in East Jerusalem and the West Bank just 24 hours after the UN agreed to officially recognise a Palestinian state, entitling the Palestinians to take part in UN debates.
The decision was opposed by the US and Britain abstained from the vote, with Mr Hague saying he could only back the move if the Palestinians agreed to return to peace talks immediately.
Matthew Gould was appointed as Britain's first Jewish ambassador to Israel in September 2010.
On taking up the post he said: "We come out determined to help build the strongest possible partnership between Britain and Israel, and to help ensure that Britain and Europe do everything they can to help the people of Israel move forward on the difficult path towards peace and lasting security."
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