Israel freed 26 veteran Palestinian prisoners Wednesday in line with commitments to the US-backed peace process, but moved in tandem to ramp up settlement in annexed east Jerusalem.

The move was denounced by the Palestinian Authority, which said it "destroys the peace process."

Plans to build another 1,500 settler homes in the city's Arab eastern sector came to light almost immediately after Israel began freeing 21 prisoners to the West Bank and another five to the Hamas-run Gaza Strip.

The sequence was almost a mirror image of August 13, when a first tranche of 26 prisoners were freed and Israel announced construction of more than 2,000 new settler homes, mostly in east Jerusalem.

"The prime minister (Benjamin Netanyahu) and the interior minister (Gideon Saar) agreed on four building plans in Jerusalem," a senior Israeli source told AFP, confirming a military radio report.

The announcement was timed to trump headlines focusing on the celebrations in the West Bank and Gaza after the 21 prisoners walked free into their respective home territories shortly after 1:00 am (2300 GMT).

In the West Bank, thousands of people turned out to welcome home the 21 prisoners at a formal ceremony at Mahmud Abbas's presidential compound in Ramallah, cheering and waving flags, many capturing the moment on cellphones.

The prisoners had left Ofer prison in two minibuses with blacked-out windows, an AFP correspondent said. They were driven to Beitunia crossing where fireworks split the night sky as they tasted freedom for the first time in 20 years or more.

After a tearful reunion with relatives, many of them were carried through the crowds on people's shoulders, their hands held aloft in victory.

"There will be no (peace) agreement if so much as one Palestinian prisoner remains behind bars," Abbas told the excited crowd, referring to the 5,000 or so inmates Israel is still holding.

In Gaza, the five ex-detainees were met by hundreds of relatives and well-wishers as they emerged through the Erez crossing and entered the strip, sparking energetic celebrations late into the night.

The move to ramp up settlements was mooted last week by a senior Israeli official who said the expected announcement on new construction had been coordinated in advance with the Palestinians and the Americans.

But Abbas, speaking shortly before the Israeli announcement, flatly denied it.

"There are some living among us who say that we have a deal (to release prisoners) in exchange for settlement building, and I say to them, be silent," said the Palestinian president.

On Wednesday, Abbas spokesman Nabil Abu Rudeina condemned the move, saying it "destroys the peace process and is a message to the international community that Israel is a country that does not respect international law."

All 26 prisoners were convicted for killing Israelis, with most of the attacks occurring before the 1993 Oslo accords, which granted the Palestinians limited self-rule but failed to usher in an independent state.

Earlier this year, Netanyahu agreed to release 104 prisoners in stages in a move which facilitated a return to direct talks in late July, ending a three-year hiatus.

The first batch of prisoners were freed on August 13, and a third release of another 26 inmates is planned for December, Palestinian officials said. The final group is to be freed in March 2014.

The ongoing talks are being conducted under a US-imposed media blackout but a senior Palestinian official said on Tuesday that Israel had adopted hardline positions and negotiations had so far produced "no tangible progress".

"The current Israeli negotiating position is the worst in more than 20 years," said Yasser Abed Rabbo, secretary general of the Palestine Liberation Organisation.

Although Israel is engaged in direct peace talks with the Palestinians, the prisoners' release has sparked tensions within Netanyahu's coalition, with the premier describing the decision to free them as "one of the most difficult" he had ever made.

Similar sentiments were expressed by Defence Minister Moshe Yaalon.

"In recent months we have been facing sensitive diplomatic circumstances and weighty strategic considerations which require us to take difficult and painful steps," he said on Tuesday in remarks communicated by his office.

"It is not a black and white situation. It is highly complex and obliges us to be prudent and responsible, to see also the long view," he said.

Yaalon's deputy Danny Danon openly opposed the prisoner release.

"I think it is wrong," he told journalists.

"Prime Minister Netanyahu has said very clearly he's willing to negotiate without preconditions.

"But by accepting the release of prisoners, he's accepting a precondition. I don't think we should pay a price in order to sit in a (negotiating) room."

"Secondly... it's a moral mistake. If somebody murdered someone ... he should sit in jail," Danon said.