The United Nations says the legislation is in violation of international law, and erodes any chance of a two-state solution to peace in the Middle East.
The law retroactively legalises 4,000 homes built illegally on privately-owned Palestinian land.
The original landowners would be compensated either with money or land elsewhere, even if they do not agree to give up their property.
The international community overwhelmingly opposes settlements and sees them as an obstacle to peace.
Israel disputes this view.
Addressing the parliament, governing Likud Party MP Ofir Akunis says the law reflects Israel's God-given right over the territory.
"We are not voting tonight only on the Regularisation bill, we are voting tonight on our right to the land. On the continuous connection of 3000 years. We're voting tonight for the connection between the Jewish people and its land. This whole land is ours. All of it."
UN Secretary General Antonio Guterres has condemned the move.
His spokesman, Stephane Dujarric, says the settlements violate international law.
"The Secretary-General deeply regrets the adoption of the so-called "Regularisation bill" on February 6th by the Knesset. This bill is in contravention of international law and will have far reaching legal consequences for Israel. It reportedly provides immunity to settlements and outposts in the occupied West Bank that were built on privately-owned Palestinian land. The Secretary-General insists on the need to avoid any actions that would derail the two-state solution. All core issues should be resolved between the parties through direct negotiations on the basis of relevant Security Council resolutions and mutual agreements."
France has also condemned the bill, saying it's a new attack on the two-state solution.
Britain says it damages Israel's standing with its international partners.
It's also drawn condemnation from Turkey and the Arab League.
The legislation is part of a series of pro-settlement steps taken in recent weeks by Israel's government, since the election of United States President Donald Trump.
Mr Trump is seen as more sympathetic to Israel's settlement policies than his predecessor, Barack Obama.
Saeb Erekat, the Secretary General of the Palestine Liberation Organisation, has called on President Trump to use his influence to urge Israel to not go ahead with the plans.
"I really urge President Trump's administration to condemn the settlement activities and to condemn this so-called Israeli law and to send a message of peace in maintaining the two-state solution by telling (Israeli Prime Minister Binyamin) Netanyahu: 'Stop it!' That's what Netanyahu needs to hear from President Trump."
The US is yet to comment on the legislation.