The Peace Now group said the plan was approved earlier this week by a municipal committee, which had given the go-ahead for construction on the site which lies on land seized by Israel in the 1967 Middle East war.
There was no immediate comment from the committee on the report, but the Palestinians said they believed the news was accurate.
"Israel's plan to build 2,610 housing units ... between Bethlehem and Jerusalem, makes a mockery of ... efforts to bring about a just and lasting peace," chief Palestinian negotiator, Saeb Erekat, said in a statement.
Direct peace talks between the Israelis and Palestinians broke down a year ago after Israel refused to bow to demands that it cease all settlement building.
The United States has tried to restart talks, but they are still held up on the settlements issue. The efforts have gained new urgency in recent weeks because of a request by President Mahmoud Abbas for UN recognition of Palestinian independence.
Washington has threatened to veto the request, arguing that a Palestinian state should come out of peace talks, but the Palestinians say that continued Israeli settlement building proves that the negotiations process is dead.
Peace Now, which closely monitors city housing activity, said the plan would create an entirely new neighborhood in an area called "Givat Hamatos" or "aircraft hill" — named after an Israel jet that fell at the site in the 1967 war.
