Israel says it will withhold $138m in tax transfers to the Palestinian Authority (PA) over payments given to Palestinians involved in attacks against Israelis.
The government's security cabinet said on Sunday it was implementing a law passed last year allowing Israel to withhold funds equivalent to those the PA pays in stipends to Palestinians jailed in Israel, their families, and released prisoners.
The money comes from taxes Israel collects on behalf of the PA.
Israel transfers the tax funds to the PA on a regular basis as outlined by a 1994 economic agreement.
'Pay for slay'
Israel says the PA's payments to the families of those jailed for attacks encourage violence - a claim the Palestinians reject.
The PA sees them as a kind of welfare system for families who have lost a breadwinner.
The system is referred to by Israel as "pay for slay".
The freeze comes as the Palestinians face major budget cuts made last year after the United States slashed funding for the UN's Palestinian refugee programme, UNRWA, and for development programmes in the Palestinian territories.
The UN's World Food Programme also cut back services due to funding shortages.
The funding reduction is a major setback for the PA, which faces constant budget shortfalls.
But Rami Hamdallah, prime minister of the Palestinian caretaker government, said the government would be able to cope with the decision, according to Palestinian news agency Maan.
"Scenarios have been put in place to deal with any deduction in tax revenues equal to the amounts of the salaries the government pays to the Palestinian prisoners in Israeli jails and the families of those killed by the Israeli occupation forces," Maan quoted him as saying on Saturday.
System part of 'life under occupation'
Speaking from Jerusalem, Al Jazeera's Harry Fawcett said that "in the face of warnings from his own security establishment", Israeli Prime Minister Benjamin Netanyahu had gone ahead with this law which "could risk making a situation more unstable".
Israel is scheduled to hold parliamentary elections on April 9, which may have influenced Netanyahu's decision.
"Netanyahu is fighting for votes on the right - his natural constituency - and he very much wants to shore it up," Fawcett said.
On the other hand, Fawcett said, the PA reacted with "outrage and fury".
"The Palestinians have accused the Israeli government of piracy, of coordinating this with the United States to add pressure ahead of the publication of the Trump peace plan," he said, referring to the so-called "deal of the century" Middle East peace plan, work on which has been led by the US president's son-in-law.
Palestinian society at large sees the prisoner welfare system as part of "life under occupation", Fawcett said, "so for the Palestinian leadership to abandon this practice, especially under Israeli pressure, would be all but politically unthinkable."
