Israeli Prime Minister Benjamin Netanyahu says settlements in the occupied West Bank will be allowed to expand despite US objections.
Mr Netanyahu said no new settlements would be built, but natural growth in existing settlements should be allowed.
During Mr Netanyahu's visit to the US last week, President Barack Obama told him all settlement activity must end.
The US regards the Jewish settlements -home to some 280,000 Israelis - as obstacles to the peace process.
"I have no intention to construct new settlements, but it makes no sense to ask us not to answer to the needs of natural growth and to stop all construction," a senior official quoted Mr Netanyahu as telling the Israeli cabinet.
"There is no way that we are going to tell people not to have children or to force young people to move away from their families," he added.
Outposts 'will go'
However, Mr Netanyahu vowed to remove makeshift outposts in the West Bank that the Israeli government itself considers illegal.
"We will take care of them, if possible by dialogue," he said. "There is no doubt that we have committed ourselves to deal with them."
The new Israeli cabinet largely opposes dismantling the outposts despite the fact that Israel agreed to it under the 2003 peace plan "roadmap".
Before the cabinet meeting, Defence Minister Ehud Barak said they would take down 22 outposts.
"The 22... have to be dealt with now in a responsible, appropriate manner, first of all, exhausting all efforts at dialogue and if that proves impossible, then unilaterally, using force if necessary," he said.
Mr Netanyahu was briefing cabinet members on his Washington visit.
President Obama urged the Israeli leader to accept a Palestinian state and said Israel had an obligation under the 2003 agreement to stop Jewish settlement in the West Bank.
Mr Netanyahu told his ministers on Sunday that "clearly we need to have some reservations about a Palestinian state in a final status agreement... when we reach an agreement on substance, we will reach agreement on terminology".
It was the first time since his election that Mr Netanyahu has publicly used the words "Palestinian state" - but he stopped short of endorsing the idea.
"If we talk about a Palestinian state, we have to first and foremost verify what kind of sovereignty and rights this state will have. We have to make sure that we are not threatened," the official quoted the prime minister as saying.
Stumbling block
Jewish settlements in the West Bank are one of the major stumbling blocks to a Middle East peace deal.
Palestinian Authority President Mahmoud Abbas has said there is no point in meeting Mr Netanyahu unless he stops settlement construction and agrees to open talks on Palestinian independence.
Israel has sanctioned 121 settlements over the years and Jewish settlers have put up an estimated 100 outposts since the early 1990s.
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