The project was first signed off in 1999, but stopped two years later after Palestinian labourers refused to go on.
Israel's housing minister said the construction at Givat Zeev would address "the demographic needs of Jerusalem".
But the decision provoked an angry reaction from Palestinian leaders.
For the Palestinians there are few issues as contentious as the building of Jewish settlements in the occupied West Bank, says the BBC's Crispin Thorold in Jerusalem.
Under the terms of the peace process settlement expansion is supposed to be frozen.
Palestinian negotiator Saeb Erekat said the latest decision raised doubts about Israel's commitment to peace talks.
"It seems to me the Israelis are determined to put a stick in the wheel of negotiations," he said.
"It will undermine the US effort to revive the negotiations."
Mr Olmert's spokesman, Mark Regev said it was not a new decision.
"This decision predates this government," he said.
"We have approved it. It is consistent with our policy of building within the large settlement blocs, which will remain in Israel in any final-status agreement," he added.
Israel Radio said the decision to restart the development was pushed by the ultra-Orthodox Shas party, which had threatened to quit the government coalition unless the construction was approved.
The decision comes three days after a Palestinian gunman opened fire in the library of a Jewish seminary in Jerusalem, killing eight young people.
The college was closely linked to the settler movement.
Israel has occupied the West Bank since 1967, settling about 400,000 Jews in the area, including East Jerusalem.
Settlements are considered illegal under international law, though Israel disputes this.
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