Israel allowed Palestinian residents of East Jerusalem to vote in Palestinian Authority elections in 1996 and at the start of the year when they elected Mahmoud Abbas as their leader.
But a spokesman for Prime Minister Ariel Sharon said Israel will not allow voting in Jerusalem for the January 25 poll because Hamas, which calls for Israel's destruction and has spearheaded a suicide bombing campaign, is running for the first time.
"There is no reason whatsoever we should assist a terrorist organisation on the ballot to gain victory. This would be like letting a Trojan horse into our city," Israeli government spokesman Raanan Gissin said.
Palestinian officials said the election may be delayed if Israel prevents voting by East Jerusalem residents.
"We cannot hold elections anywhere if the Palestinians in Jerusalem are not allowed to vote," said senior Palestinian official Nabil Shaath.
Mr Abbas denounced Israel's decision saying "this is a very dangerous situation", adding that he would "study" the issue.
Hamas spokesman Sami Abu Zuhhri said the Palestinian Authority should "multiply its contacts with the parties concerned to facilitate the holding of elections as was the case in the presidential election."
No obstacles
The US predicted the sides would find a solution to the voting in Jerusalem and said the Palestinians could still hold the election on time despite Israel's move.
"At this point, we see no obstacles to those elections taking place as scheduled on January 25th with concerted effort and focus on the part of the Palestinians to see that those elections take place," State Department spokesman Sean McCormack said.
A Hamas spokesman said the group, which is expected to make a strong showing in the poll, demanded it be held on time.
He would not specify whether that position would remain the same if East Jerusalem Palestinians could not vote.
Palestinian residents of East Jerusalem carry Israeli identity cards, but see themselves as the citizens of a future Palestinian state with East Jerusalem as its capital.
Poll violence
Israel has sought Egypt's help to halt a feared upsurge in violence ahead of the polls.
Defence Minister Shaul Mofaz held talks with Egypt's intelligence services chief Omar Suleiman to use Cairo's influence on militant groups, accusing Mr Abbas's administration of sitting on its hands.
While Mr Mofaz was looking for outside help to rein in groups such as Hamas, the Israeli army was taking action on the ground, killing a local leader of the radical Islamist movement during an arrest operation in the West Bank city of Jenin.
Paramedics said Zayed Mussa, 28, was killed in exchanges during the course of an Israeli incursion.
The army confirmed a gunman had been killed, saying a firearm and two magazine clips had been found on his body.
Israel captured and then annexed east Jerusalem after the 1967 war but the international community still regards the area, home to nearly 200,000 Palestinians, as occupied territory.