The security cabinet voted unanimously late on Thursday to begin construction on a hilltop known as “Geulat Zion”, near the Palestinian city of Nablus.
It will be used to house some 40 families whose homes were cleared from an unauthorised settlement outpost.
Palestinian officials have condemned the move and called on the international community to intervene.
It comes despite US President Donald Trump asking Israeli Prime Minister Benjamin Netanyahu last month to “hold back” on settlement construction.
The Israeli authorities approved thousands of new homes in existing settlements after Mr Trump took office in January.
More than 600,000 Jews live in about 140 settlements built since Israel’s 1967 occupation of the West Bank and East Jerusalem – land the Palestinians claim for a future state. The settlements are considered illegal under international law, though Israel disputes this.