The move was denounced by the Palestinian Authority, which said it "destroys the peace process."
Plans to build another 1,500 settler homes in the city's Arab eastern sector came to light almost immediately after Israel began freeing 21 prisoners to the West Bank and another five to the Hamas-run Gaza Strip.
The sequence was almost a mirror image of August 13, when a first tranche of 26 prisoners were freed and Israel announced construction of more than 2,000 new settler homes, mostly in east Jerusalem.
The announcement was timed to trump headlines focusing on the celebrations in the West Bank and Gaza after the 21 prisoners walked free into their respective home territories shortly after 1:00 am (2300 GMT).
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In the West Bank, thousands of people turned out to welcome home the 21 prisoners at a formal ceremony at Mahmud Abbas's presidential compound in Ramallah, cheering and waving flags, many capturing the moment on cellphones.
The prisoners had left Ofer prison in two minibuses with blacked-out windows, an AFP correspondent said. They were driven to Beitunia crossing where fireworks split the night sky as they tasted freedom for the first time in 20 years or more.
"There will be no (peace) agreement if so much as one Palestinian prisoner remains behind bars," Abbas told the excited crowd, referring to the 5,000 or so inmates Israel is still holding.
In Gaza, the five ex-detainees were met by hundreds of relatives and well-wishers as they emerged through the Erez crossing and entered the strip, sparking energetic celebrations late into the night.
The move to ramp up settlements was mooted last week by a senior Israeli official who said the expected announcement on new construction had been coordinated in advance with the Palestinians and the Americans.