The Israeli Security Cabinet on Sunday voted to withhold $43 million of tax funds from the Palestinians, saying the money has been used to promote violence.
The sum represents funds that Israel says the Palestinians have used to pay the families of those who have been jailed or killed as a result of attacks on Israel, reports claim.
Israel says the Martyrs' Fund rewards violence. Palestinians say the payments are needed to help vulnerable families who have been affected by violence and Israeli occupation.
Under past agreements, Israel collects Customs and other taxes on behalf of the Palestinians and transfers the money to the Palestinian Authority.
These monthly transfers, about $170m, are a key source of funding for the budget of the authority, which administers parts of the Israeli-occupied West Bank.
Israel last year passed a law deducting parts of these transfers that it said were supporting militants' families. Sunday's decision was a continuation of that policy.
In February, after Israel withheld $140m, the Palestinians said they would reject all transfers to protest against the policy.
But six months later, with the Palestinian Authority in a deep financial crisis, the sides worked out a deal to resume most of the transfers.
Palestinian official Hanan Ashrawi denounced the latest Israeli move, calling it a “blatant act of theft and political extortion".
“This is a clear violation of Palestinian rights and signed agreements, as well as a criminal act of collective punishment exacted for cynical domestic Israeli political reasons,” Ms Ashrawi said.
Prime Minister Benjamin Netanyahu's office declined to comment.
