JERUSALEM, March 15 (Reuters) - Prime Minister Benjamin Netanyahu rejected on Monday any curbs on Jewish settlement in and around Jerusalem, defying Washington in Israel's deepening crisis with US President Barack Obama's administration.

For the past 40 years, no Israeli government ever limited construction in the neighborhoods of Jerusalem, he said in a speech in parliament, citing areas in the West Bank that Israel captured in a 1967 war and annexed to the city.

The United States has condemned Israel's plan to build 1,600 new homes for Jews in Ramat Shlomo, a religious settlement within the Israeli-designated borders of Jerusalem, whose future status is at the heart of the Middle East conflict.

Israel's announcement of the project during a visit last week by US Vice President Joe Biden embarrassed the White House. US Secretary of State Hillary Clinton, in unusually blunt remarks, called it an insult.

The Palestinians, who had just agreed to begin indirect peace talks under US mediation, said they would not go ahead unless the plan was scrapped. Israel has said construction at the site would not begin for several years.

In parliament, Netanyahu, who heads a coalition that includes pro-settler parties, including his own, said there was nearly total consensus in Israel that annexed areas of Jerusalem would be part of the Jewish state in any future peace deal.

He made the comments -- signaling to Washington he believed he had political backing at home to withstand pressure over Jerusalem -- after Israeli media said Clinton had demanded the decision to build in Ramat Shlomo be reversed.

Netanyahu imposed a limited moratorium on new housing starts in West Bank settlements in November but excluded Jerusalem from the 10-month partial freeze that Palestinians termed inadequate and the Obama administration welcomed at the time.

On Sunday, Netanyahu tried to play down what his envoy to Washington was reported to have described as a crisis of historic proportions, voicing regret at a cabinet meeting for the timing of the Ramat Shlomo project's announcement.

The rift with Washington has raised concern in Israel that security cooperation with the United States in the face of a possible nuclear-armed Iran might be compromised.

In the West Bank city of Ramallah, Nabil Abu Rdainah, an aide to Palestinian President Mahmoud Abbas, responded to Netanyahu's comments at the parliamentary session by pledging again not to return to peace talks until settlement was halted.

U.S. ENVOY

Abbas had voiced that demand in resisting US calls to revive negotiations suspended since December 2008 but agreed last week to indirect talks after receiving backing from the Arab League and the Palestine Liberation Organization.

Obama's Middle East envoy, George Mitchell, was expected to return to the region later this week to try to get negotiations under way.

In the West Bank, Israeli troops injured at least seven Palestinians during a rock-throwing protest against the Ramat Shlomo project and Israel's consecration of a centuries-old synagogue in the Jewish Quarter inside Jerusalem's walled Old City, a tinderbox site in the Israeli-Palestinian conflict.

Palestinians said the soldiers had fired live rounds at the demonstrators but the Israeli military denied this, saying crowd-dispersal measures had been employed.

Tensions between Palestinians and Israel, which has occupied the West Bank since 1967, have escalated in recent weeks following an Israeli government decision to include West Bank religious sites in a Jewish national heritage plan.

Citing biblical and historical links, Israel sees all of Jerusalem as its capital, a claim that is not recognised internationally. Palestinians want East Jerusalem to be the capital of a future state in the West Bank and Gaza Strip.

Some 500,000 Jews live in the West Bank and East Jerusalem, which was also captured by Israel in 1967. There are about 2.5 million Palestinians in the same areas.