By Adrian Croft and Allyn Fisher-Ilan
BRUSSELS/JERUSALEM (Reuters) - The European Union said on Tuesday it will bar financial assistance to Israeli organizations operating in the occupied territories, a move Israel's prime minister denounced as meddling in bilateral relations with the Palestinians.
Guidelines adopted by the EU's Executive Commission in late June and expected to be published this week make clear that, from next year, Israeli "entities" operating in the territories will not be eligible for EU grants, prizes or loans.
The measure, which underlines EU opposition to Israeli settlement-building, will apply to Israeli companies, universities or other bodies operating in areas occupied by Israel since the 1967 Middle East War, including the Golan Heights, the West Bank and East Jerusalem.
"The EU has made it clear that it will not recognize any changes to pre-1967 borders, other than those agreed by the parties to the Middle East Peace Process," a copy of the guidelines seen by Reuters said.
The decision could make it politically difficult for the Jewish state's pro-settlement government, which has called those narrow boundaries indefensible, to sign accords with the 28-nation EU.
Israeli Prime Minister Benjamin Netanyahu criticized the EU, saying it instead should focus on "problems that are slightly more urgent in the region, like the civil war in Syria, or Iran's race to obtain a nuclear weapon".
"We will not accept any external dictates regarding our borders. This issue will be determined only in direct negotiation between the sides," Netanyahu said in broadcast remarks.
Palestinians praised the rule as a concrete step against settlement construction they fear will deny them a viable state.
Sandra de Waele, the EU delegation to Israel's head of political affairs, said on Israel Radio the guidelines codified EU policy that "agreements and financial instruments that benefit Israel" should not apply to activities or entities in territory it captured in the 1967 war.
The EU decision was an expression of "frustration with continued settlement expansion", she added.
The EU move came to light as U.S. Secretary of State John Kerry, who is attempting to revive Israeli-Palestinian peace talks, embarked on his sixth visit to the Middle East since taking office in February.
The guidelines are in line with a call by EU foreign ministers last December for all agreements between Israel and the EU to "unequivocally and explicitly indicate their inapplicability to the territories occupied by Israel in 1967."
The EU, which has been pressing for direct talks to resolve the Israeli-Palestinian conflict, has taken a strong stance against Israeli plans to expand settlements in the West Bank, saying it would undermine prospects for a negotiated solution.
Some 500,000 Israelis have settled in the West Bank and East Jerusalem among about 2.5 million Palestinians. Palestinians seek a state in the West Bank and Gaza Strip, with East Jerusalem as its capital.
Israel signaled its concern that Palestinians would now feel emboldened to stick to their demand that settlement construction be frozen before any resumption of peace talks that collapsed over the issue in 2010.
Israeli officials have voiced alarm over escalating attempts by pro-Palestinian campaigners in Europe to isolate the country through academic and commercial boycotts over its settlement policies.
"The European Union's decision signals to the Palestinians that there is no international or economic price to pay for their on-going refusal to return to the talks, and it leads them to believe that Israel will be forced to surrender to economic and diplomatic pressure," said Finance Minister Yair Lapid.
Hanan Ashrawi, a senior member of the Palestine Liberation Organization, said the EU had moved beyond "statements, declarations and denunciations" over Israel's settlement policy and made a "qualitative shift" that would improve peace prospects.
Israel, which has urged the Palestinians to return to talks unconditionally, disputes the view of the EU, the International Court of Justice, and most countries that the settlements are illegal. It regards all of Jerusalem as its capital, a claim that has not won international recognition.
Maja Kocijancic, a spokeswoman for EU foreign policy chief Catherine Ashton, said the Commission drew up the guidelines in response to a request from the European Parliament and said they clarified a system that the EU was already applying.
She said there had been a small number of cases in the past where Israeli organizations operating in the occupied territories had received EU funds, but she could not provide a figure for the potential financial impact of the measure.
(Additional reporting by Ali Sawafta in Ramallah, Editing by Jeffrey Heller and Michael Roddy)