Israel's Ambassador to Washington Michael Oren said the spat is the most serious since 1975 when the US demanded a partial Israeli withdrawal from Egypt's Sinai peninsula.

But Secretary of State Hillary Clinton insisted: "The worst crisis in 35 years? I don't buy that. We have an absolute commitment to Israel's security."

The storm erupted last week when Israel announced the building of 1,600 new housing units in the east Jerusalem neighbourhood of Ramat Shlomo - causing humiliation for the visiting US Vice-President Joe Biden.

Despite attempts by premier Benjamin Netanyahu to project a sense of "business as usual", envoy Oren said the difference of opinions was of "historic" proportions.

However, in the first public signs that the crisis was winding down, Clinton said on Tuesday: "There is a close, unshakable bond between the United States and Israel."

She added that both countries were also committed to a two-state solution.

"But that doesn't mean that we are going to agree," Clinton went on.

"We don't agree with any of our international partners on everything." She also said the US was "engaged in very active consultations with the Israelis over steps that we think would demonstrate the requisite commitment to the process."

In Jerusalem, Netanyahu's office - eager to put an end to the embarrassing spat - jumped on Clinton's remarks, declaring that it appreciated her "warm words".

Netanyahu told the Knesset on Monday: "The building of those Jewish neighbourhoods in no way hurt the Arabs of east Jerusalem."

He noted that Israel has been building there for more than 40 years.

"There was a regrettable incident that was done in all innocence and was hurtful, and which certainly should not have occurred," he added.

At the same time, he urged his Cabinet "not to get carried away and to calm down" - and gave no sign he would scrap the settlement plan.