Israel's cabinet said it would withhold more than $100 million in taxes and other revenues that Israel collects on behalf of the Palestinian Authority.
The move comes after the Palestinian Authority's successful bid last week to upgrade its UN status from "entity" to "nonmember state."
Israeli Finance Minister Yuval Steinitz said the tax money would be used to pay down the Palestinian Authority's debt to the Israeli electricity company and other Israeli entities.
The cabinet also announced the UN decision would not serve as a basis for future negotiations between Israel and the Palestinians.
Speaking at the cabinet meeting, Prime Minister Benjamin Netanyahu brushed off criticism of Israel's plans to expand Jewish settlements.
"Today we are building and we will continue to build in Jerusalem and in all areas that are on the state of Israel's map of strategic interests," he said.
On November 30, Israel announced it would move ahead with building 3,000 more Jewish settler homes in East Jerusalem and the West Bank.
The Palestinians want a future state to include the West Bank and have East Jerusalem as its capital.
Meanwhile, thousands of Palestinians thronged the streets of Ramallah as Palestinian President Mahmud Abbas returned to his headquarters following the victory in the UN.
"Yes, we now have a state," Abbas told the cheering crowd in the West Bank.
"Congratulations to all of you brave Palestinians -- you alone have accomplished this achievement and alone have won this victory," he said.
He pledged to turn his attention to achieving reconciliation between Fatah and Hamas, the two main Palestinian political factions.
Based on reporting by AP and AFP