"This is a programme which was approved by the regional (planning and construction) committee two years ago," spokeswoman Efrat Orbach said.
"According to the planning process in Israel, (it) needed the completion of amendments, therefore it was finally approved today."
The approval marks the final planning stage for a project that has garnered fierce criticism from the Palestinians and the international community.
It will significantly expand the hilltop neighbourhood, which lies in Jerusalem's southwest and is defined as being within the municipal boundaries despite lying directly next to the Palestinian West Bank town of Bethlehem.
Hagit Ofran, who monitors settlement activity for the Israeli group Peace Now, described the final approval of the project as "a very dramatic development" because of where the new housing will be located.
"It adds a new ridge to Har Homa which blocks the territorial contiguity between east Jerusalem and Bethlehem and adds a further barrier to the possibility of east Jerusalem as the Palestinian capital in a two-state solution," she told AFP.
Israel captured Arab east Jerusalem along with the rest of the West Bank in the 1967 Six Day War and later annexed it in a move not recognised by the international community.
Israel does not view construction in the east to be settlement activity, calling both east and west Jerusalem its "eternal, indivisible" capital, and some 180,000 Israelis now live in east Jerusalem amid nearly 270,000 Palestinians.
But the Palestinians view settlement construction in mostly-Arab east Jerusalem as an Israeli attempt to extend control over the sector of the city that they want for the capital of their future state.
And the international community, including the United States, has regularly criticised Israel for building settlements in the West Bank and particularly east Jerusalem, describing them counterproductive and calling for a halt to all such construction.
Israel's settlement construction has also snarled peace talks, which were restarted in September 2010 but ground to a halt shortly after they began when a partial Israeli ban on settlement building expired.
Israel declined to renew the freeze, which covered the West Bank but not east Jerusalem, and the Palestinians say they will not negotiate will Israel builds on land they want for their future state.