Science and Technology Minister Ofir Akunis of Netanyahu's Likud party said the argument was over the right to the Land of Israel. Opposing the law would have risked alienating his supporters and ceding ground to Jewish Home.
The private Palestinian land would be seized by the government and held until there is a final resolution of decades-long Israel-Palestinian conflict.
The Palestinian Authority said the measure was "an illegal land grab". Likud MK Benny Begin voted with the opposition, whose leader, Yitzhak Herzog of Labor said that the law is a black flag and exposes IDF officers and men to prosecution before the war crimes court at The Hague. They say the settlements, home to 600,000 Israelis, are making it increasingly impossible to partition the land into two states - a position that has wide worldwide backing.
The Amona settlement outpost file has been open for years, since it was built on private Palestinian land, for which Palestinians have petitioned and won the case.
Houses in the West Bank Jewish settlement of Karmel, near Hebron, on May 24.
Global law considers all settlements to be illegal, but Israel distinguishes between those it sanctions and those it does not, dubbed outposts.
"The controversial Knesset action, ahead of Prime Minister Netanyahu's meeting with President Trump in Washington, is misguided and likely to prove counter-productive to Israel's core national interests", said AJC CEO David Harris.
"The law passed by the Knesset today proves yet again that Israel has no intention of ending its control over the Palestinians or its theft of their land", the group said in a statement.
Adalah, an Israeli group that protects Arab rights, said it would immediately file a challenge in the Supreme Court if the bill is approved.
But after Netanyahu announced plans to build over 6,000 new settler homes during Trump's first two weeks in office, the White House over the weekend signaled that it too may have its limits. The bill retroactively gives the Israeli government's blessing to settlements originally constructed without government approval.
Netanyahu did not participate in the vote since he was returning from a trip to London.
Nickolay Mladenov, UN envoy for the Middle East peace process, said on Monday that he was "concerned" by the recent bill as it would "enable the continued use of privately owned Palestinian land for Israeli settlements". "I don't get excited", Netanyahu said in an apparent reference to his Jewish Home allies.
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