JERUSALEM, Jan 10 (Reuters) - Israeli Prime Minister Benjamin Netanyahu, saying Jews have a right to live anywhere in Jerusalem, defended on Monday a settlement project that drew criticism from U.S. Secretary of State Hillary Clinton.

Israeli bulldozers cleared the way for 20 new homes for Jews in East Jerusalem, an area captured by Israel in a 1967 war and which Palestinian want as the capital of a future state, by demolishing a derelict hotel on Sunday.

Clinton, in Abu Dhabi on a tour of U.S. Gulf Arab allies, called the Israeli action a disturbing development and said it undermines peace efforts to achieve the two-state solution.

A statement issued by Netanyahu's office made no direct reference to Clinton's criticism, but said there should be no expectation that the State of Israel will impose a ban on Jews purchasing private property in Jerusalem.

The Shepherd Hotel, torn down as part of a project first announced in 2009, was declared absentee property by Israel after it captured and annexed East Jerusalem. Israel views all of Jerusalem as its capital, a claim that is not recognised internationally.

The title of the hotel was transferred to an Israeli firm, which sold it in 1985 to Irving Moskowitz, a U.S.-based patron of Jewish settlers.

Actions undertaken yesterday at the Shepherd Hotel were conducted by private individual in accordance with Israeli law. The Israeli government was not involved, the statement from Netanyahu's office said.

It added, however, no democratic government in the world would prohibit Jews from buying real estate, and Israel will certainly not do so. Jews, the statement said, can buy or rent property in predominantly Arab neighbourhoods in Jerusalem.

The settlement project at the hotel compound, whose ownership is contested, stoked Palestinian anger as Washington tries to revive peace talks stalled by a dispute over Israeli settlement construction in the West Bank and East Jerusalem.

Some 190,000 Israelis live in East Jerusalem and adjacent areas of the West Bank that Israel annexed to its Jerusalem municipality. East Jerusalem has 250,000 Palestinian residents. (Writing by Jeffrey Heller, Additional reporting by Andrew Quinn in Abu Dhabi; Editing by Jason Neely)