The law -- approved by 60 members of parliament to 52 against -- was slammed by the Palestinians as a means to ‘legalise theft’ of land.
Prime Minister Benjamin Netanyahu, who did not participate in the law's final votes since he was returning from a trip to Britain, said he had ‘updated’ the US administration so as not to surprise ‘our friends’.
Speaking after the law was finalised, Bezalel Smotrich of the far-right Jewish Home party, who was one of the forces behind the legislation, thanked the American people for electing Donald Trump as president, ‘without whom the law would have probably not passed’.
The new law will allow Israel to legally seize Palestinian private land on which Israelis built outposts without knowing it was private property or because the state allowed them to do so.
Palestinian owners will be compensated financially or with other land.
The Palestine Liberation Organisation said the law was a means to ‘legalise theft’ and demonstrated ‘the Israeli government's will to destroy any chances for a political solution’.
A PLO statement stressed that the ‘Israeli settlement enterprise negates peace and the possibility of the two-state solution’.
Ahead of the vote, opposition chief and Labour leader Isaac Herzog lashed out against the ‘despicable law’ that he said would undermine the country's Jewish majority.
‘The vote tonight isn't for or against the settlers, rather Israel's interests,’ Herzog said.
The law would ‘annex millions of Palestinians into Israel’, he warned, and expose Israeli soldiers and politicians to lawsuits at international criminal courts.
Science and Technology Minister Ofir Akunis of Netanyahu's Likud party said the argument was over the right to the Land of Israel.
‘All of the Land of Israel belongs to the Jewish people,’ he told Herzog, using the biblical term that included the West Bank. ‘This right is eternal and indisputable.’
The law is seen by critics as promoting at least partial annexation of the West Bank, a key demand for parts of Netanyahu's right-wing cabinet, including Jewish Home.
Human Rights Watch said the law ‘reflects Israel's manifest disregard of international law’ and deepens the ‘de facto permanent occupation’ of the West Bank, warning that ‘the Trump administration cannot shield them from the scrutiny of the International Criminal Court’.
Israeli rights group B'Tselem said the law proved Israel ‘has no intention of ending its control over the Palestinians or its theft of their land’.
The bill could still be challenged, with Defence Minister Avigdor Lieberman saying last week: ‘The chance that it will be struck down by the Supreme Court is 100 percent.’
Last week, the few hundred residents of the Amona outpost in the West Bank were evicted after the Supreme Court ruled their homes were built on private Palestinian land.
- Amona demolitions -
In parliament on Monday, Shuli Mualem of Jewish Home dedicated the law to those evicted from Amona.
International law considers all settlements to be illegal, but Israel distinguishes between those it sanctions and those it does not, dubbed outposts.
The lengthy Amona saga -- including the evictions broadcast live on Israeli television -- directly inspired the bill.
Demolitions and removal of the buildings there began on Monday.
The law applies to 53 other outposts and homes within existing settlements recognised by Israel built on Palestinian land, according to the anti-settlement organisation Peace Now.
More than 3,800 homes would be ‘legalised’, the NGO said ahead of the vote.
UN envoy for the Middle East peace process Nickolay Mladenov said he was ‘concerned’ by the law, which could ‘greatly diminish the prospects for Arab-Israeli peace’.
Since Trump's inauguration, Israel has announced more than 6,000 new homes in the West Bank and east Jerusalem, seen as key parts of any future Palestinian state.
For the first time last week Trump's administration said settlement expansion ‘may not be helpful’ for peace prospects, but also broke with previous administrations by saying settlements were not an obstacle to peace.
The White House statement was interpreted as a message to Netanyahu and his government that the US administration intended to reserve its options.
Washington Monday refused to comment on the new law.
‘At this point, indications are that this legislation is likely to be reviewed by the relevant Israeli courts, and the Trump administration will withhold comment on the legislation until the relevant court ruling,’ a State Department official told AFP.
Israeli Attorney General Avichai Mandelblit has warned the government that the law could be unconstitutional and risks exposing Israel to international prosecution for war crimes.