JERUSALEM, Jan 9 (Jeffrey Heller/Reuters) - Israeli bulldozers cleared the way for 20 new homes for Jews in East Jerusalem by demolishing a derelict hotel on Sunday, in a settlement project that angered Palestinians and drew criticism from the United States.

Construction at the Shepherd Hotel compound, whose ownership is contested, was likely to deepen Israeli-Palestinian acrimony as Washington tries to revive peace talks. The negotiations are stalled by a dispute over Israel's settlement policy in the West Bank and East Jerusalem, areas captured in a 1967 war.

What is happening today is part of the political program of the Israeli government to preempt any solution on Jerusalem, Palestinian chief negotiator Saeb Erekat said in a statement.

US Secretary of State Hillary Clinton, in Abu Dhabi on a tour of US Gulf Arab allies, said: This disturbing development undermines peace efforts to achieve the two-state solution. In particular, this move contradicts the logic of a reasonable and necessary agreement between the parties on the status of Jerusalem.

With direct Israeli-Palestinian negotiations at a standstill, Israel said an emissary of Prime Minister Benjamin Netanyahu and a Palestinian envoy would travel to Washington in the next few days to seek ways to restart talks.

But Erekat said the meetings, if they happen, will happen on a separate basis with the American administration: Palestinian-American, Israeli-American.

He accused Netanyahu of waging a public relations campaign on peace while on the ground rapidly moving to prevent the establishment of a sovereign Palestinian state. Netanyahu has urged the Palestinians to return to direct talks.


ABSENTEE PROPERTY

In the predominantly Arab neighborhood of Sheikh Jarrah, bulldozers tore into the decaying hotel built in the 1930s for Muslim grand mufti Haj Amin Husseini, who fought the British and Zionists and became a World War Two ally of Hitler.

A project to replace the building with a block of 20 apartments was approved by Israel's Jerusalem city hall in 2009. Israeli officials said Washington had voiced its opposition to the project to Israel's ambassador in the United States.

Netanyahu responded at the time to the US criticism by saying that Jews have a right to live anywhere in Jerusalem, a city Israel claims as its united capital -- a designation that has not won international acceptance.

Palestinians want East Jerusalem to be the capital of the state they seek to establish in the West Bank and Gaza Strip.

Clinton said the United States believed that negotiation was the only way to realize the aspirations of both parties for Jerusalem and said Washington would continue to press both sides to resolve core issues.

No violence was reported after the demolition in Sheikh Jarrah, where evictions of Palestinian families from homes that Israeli courts have ruled were owned in the past by Jews or purchased from Arabs have led to anti-settler protests.

The hotel was declared absentee property by Israel after it captured and annexed East Jerusalem. The title was transferred to an Israeli firm, which sold it in 1985 to Irving Moskowitz, a Florida bingo king and patron of Jewish settlers.

Adnan Husseini, the Palestinian Authority-appointed mayor of Jerusalem, said knocking down the historic building was an act of barbarism.

His family claims ownership of the property and had been using the Israeli courts to challenge the steps that had led to its sale.

Some 190,000 Israelis live in East Jerusalem and adjacent areas of the West Bank that Israel annexed to its Jerusalem municipality after the 1967 conflict. East Jerusalem has 250,000 Palestinian residents. (Additional reporting by Ali Sawafta and Tom Perry in Ramallah; Andrew Quinn in Abu Dhabi; Editing by Mark Trevelyan)