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Israel's plan to build new settlements in a politically sensitive area near East Jerusalem drew sharp international criticism over the weekend as Palestinian Authority President Mahmoud Abbas returned home to a hero's welcome after winning observer-state status at the UN.

The United States, the European Union, and the United Nations warned that the plan Israel announced on Friday to build 3,000 new homes in the so-called E1 corridor, which links sections of the West Bank, would be an almost-fatal blow to efforts to negotiate a lasting peace.

In Ottawa, however, the Harper government delivered a more muted response. "Canada's position is that unilateral actions on either side do not advance the peace process," said Mr. Harper's spokesman, Andrew MacDougall.

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The fallout from a vote on Thursday at the UN to grant observer-state status to the Palestinian Authority continued to ripple throughout the region and the world, leaving nations grappling with its impact on the future of the moribund Middle East peace process – and Ottawa struggling to chart its next moves.

Foreign Affairs Minister John Baird is set to meet with this week with Ottawa's envoys to the Middle East and the UN, who were temporarily recalled last week for consultation on as-yet-unspecified "next steps" to express disapproval of the Palestinian Authority.

The Harper government, which opposed granting observer-state status, says it will not break off relations, but is reviewing the five-year, $300-million aid package for the Palestinian Authority that comes up for renewal in April.

Prime Minister Stephen Harper spoke by telephone on Saturday to Israeli Prime Minister Benjamin Netanyahu, who called to thank him for Canada's UN vote, Mr. MacDougall said. He would not say what else the two leaders discussed.

Ottawa had lobbied hard against the Palestinian resolution, but was on the losing side of a 138 to nine vote. Now, it must measure whether punitive steps against Mr. Abbas's Palestinian Authority such as cutting aid would only further damage relations with Palestinian moderates.

Mr. Abbas's Fatah faction endorses a negotiated two-state Middle East peace, but is struggling for credibility at home with Islamist rivals in Hamas.

In the West Bank, Mr. Abbas, who made the bid for "observer state" status a personal mission, returned to jubilation. And though the UN vote has no effect on the ground, he cast it as a major milestone.

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"Now we have a state," he told cheering crowds. "The world said in a loud voice … yes to the state of Palestine, yes to Palestine's freedom, yes to Palestine's independence, no to aggression, no to settlements, no to occupation."

But the celebrations will come with repercussions. Israel announced on Sunday it will withhold $100-million in taxes this month that it collects for the Palestinians.

And at a weekly cabinet meeting, Mr. Netanyahu spoke defiantly about settlement plans. "We will carry on building in Jerusalem and in all the places that are on the map of Israel's strategic interests," he said.

The settlement plans, in particular, have caused several western nations to worry that the tit-for-tat response to the upgrade in Palestinian status in the UN could go too far, too quickly.

U.S. Secretary of State Hillary Clinton warned the settlement plan would "set back the cause of a negotiated peace," while UN Secretary-General Ban Ki-Moon said that if it goes ahead, it will be "an almost fatal blow" to peace talks.

Although actual construction would probably not begin for years, the plan to build in the E1 corridor marks a potential elevation of tensions. Because the area links major sections of the West Bank that Palestinians would expect to form part of an independent state in a negotiated peace, some worry that Israeli settlements would preclude a negotiated two-state solution.

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"I know a lot of critics on the Israeli side, as well, are very worried about building there. Because it essentially will cut the northern part of the West Bank away from the southern part, geographically," said University of Windsor Middle East expert Michael Bell, a former Canadian ambassador to Israel, Egypt and Jordan.

"You are splitting the West Bank into two pieces, which is simply not going to work in terms of satisfying the Palestinians that they will have a geographically contiguous territory."

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