Israeli PM Benjamin Netanyahu and US envoy George Mitchell on the plans
Israel's prime minister has offered a 10-month restriction on new residential building in Jewish settlements in the West Bank, but not East Jerusalem.
Benjamin Netanyahu said the "policy of restraint" was a far-reaching step which he hoped would give new impetus to peace talks with the Palestinians.
The Palestinians have refused to attend any talks until Israel stops building settlements on all occupied territory.
The US said Israel's decision would help "move forward" peace efforts.
"We believe that through good-faith negotiations the parties can mutually agree on an outcome which ends the conflict and reconciles the Palestinian goal of an independent and viable state based on the 1967 lines, with agreed swaps, and the Israeli goal of a Jewish state with secure and recognised borders," US Secretary of State Hillary Clinton said in a statement.
US Middle East envoy George Mitchell said the move did not represent a settlement construction freeze, but was nevertheless "significant" and might have "a substantial impact on the ground".
'Normal life'
In a televised statement, Mr Netanyahu said the Israeli security cabinet had earlier authorised the "policy of restraint regarding settlements which will include the suspension of new permits and new construction in [the West Bank] for a period of 10 months".
The exclusion of Jerusalem is a very, very serious problem for us
"This is a far-reaching and painful step," he said.
"We hope that this decision will help launch meaningful negotiations to reach an historic peace agreement that will finally end the conflict between Israel and the Palestinians."
Mr Netanyahu said the restrictions would apply only to the construction of new homes, and that any work currently under way would continue.
"We will not halt existing construction and we will continue to build synagogues, schools, kindergartens and public buildings essential for normal life," he added.
He also stressed that the policy did not apply to Jerusalem, saying: "We do not put any restrictions on building in our sovereign capital."
BBC's Katya Adler: "Palestinians are calling for a complete settlement freeze"
Reacting to earlier reports of the announcement, Palestinian Prime Minister Salam Fayyad said: "The exclusion of Jerusalem is a very, very serious problem."
"Since it is only a moratorium we are speaking about, why is it so difficult for the Israelis to see the benefit of nothing more than compliance with international law or to stop violating international law?"
A spokesman for Palestinian Authority President Mahmoud Abbas was quoted as saying any settlement freeze must be on the basis of a complete freeze, "and in Jerusalem first".
The BBC's Katya Adler in Jerusalem says many will see Wednesday's announcement as a cynical move to appease the US.
The row over settlements has dogged US President Barack Obama's attempts to restart peace talks between Israel and the Palestinians for months.
Obama warning
Israel previously pledged to freeze all settlement activity under the 2003 Middle East peace plan known as the roadmap.
However, the administration of former US President George W Bush did not pressure it to curtail building in settlement blocs it was widely expected to keep in an eventual deal.
Mr Obama's administration began by pressing for a total freeze, but softened its language in the face of refusals from Mr Netanyahu and his right-leaning government.
Last week, the Israeli interior ministry approved planning applications for 900 extra housing units at the settlement of Gilo in East Jerusalem, reportedly after Mr Netanyahu rejected a request from US President Barack Obama not to do so.
Mr Obama later warned that additional settlement building did not contribute to Israel's security, but embittered the Palestinians "in a way that could end up being very dangerous".
Nearly 500,000 Jews live in more than 100 settlements built on occupied territory in the West Bank and East Jerusalem.
A number of UN Security Council resolutions have condemned settlement building in the occupied West Bank, including East Jerusalem, as illegal - although Israel disputes this.
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The exclusion of Jerusalem is a very, very serious problem for us
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