* Germany, France and Sweden protest against settler plans
* Netanyahu said to have plan to remove unauthorised outposts
(Adds Israel shuts East Jerusalem Palestinian fair, para 12)
By Allyn Fisher-Ilan
JERUSALEM, July 21 (Reuters) - Germany, France and EU president Sweden on Tuesday joined Western nations pressing Israel to stop building settlements in East Jerusalem and the West Bank under a U.S.-led effort to resume stalled peace talks.
Israeli Prime Minister Benjamin Netanyahu, who has resisted international calls to freeze building in occupied territory, seemed to show a sign of flexibility as a newspaper reported a secret plan to remove two dozen unauthorised settler outposts.
Israel has long pledged to dismantle hilltop outposts that it never approved, but has continued building larger settlements in East Jerusalem and the West Bank, land it captured in a 1967 war, and where Palestinians want to build a future state.
Western-backed Palestinian President Mahmoud Abbas has said he would not resume peace talks with Israel, stalled since Israel elected Netanyahu, a right-wing settler champion in February, unless all settlement construction stopped.
In Berlin, Ruprecht Polenz, a senior member of German Chancellor Angela Merkel’s conservative party, was quoted as saying Israel ran the risk "of gradually committing suicide as a democratic state" if it did not stop the construction.
Polenz, head of the German parliament’s Foreign Affairs Committee, further told the Rheinische Post daily that "Israel is overlooking the fact that neither Palestinians nor Arab states will agree to a solution without East Jerusalem."
The French Foreign Ministry summoned Israel’s ambassador, Daniel Shek, in Paris, to protest against a planned Israeli housing project for East Jerusalem, which Israel considers part of its capital and which Palestinians also seek to make their capital.
Israel annexed East Jerusalem shortly after its capture, in a move never recognised internationally.
THOUSANDS THREATENED WITH DISPLACEMENT
European Union president Sweden urged from Stockholm that Israel refrain from demolishing homes in East Jerusalem where thousands are threatened with displacement.
Jerusalem has emerged as a focal point of the settlement controversy since Israeli officials accused the U.S. State Department on Sunday of telling Israel’s ambassador to Washington, Michael Oren, Israel should suspend plans to build about 20 housing units in the city’s eastern sector.
The United States has never confirmed it made this demand, but Netanyahu rejected it in televised remarks to his cabinet, a move analysts saw as capitalising on broad popular support in the country for Israel’s continued control of the disputed city.
Israel shut a hotel fair in East Jerusalem in the latest of several Palestinian cultural events it has disrupted in recent months saying an interim peace deal permits it to bar the Palestinian government from holding events in the city.
"They want us to leave Jerusalem, but we will not," Rafiq al-Husseini, an aide to Abbas, said. Neither Netanyahu’s office nor the Israeli army would comment on a report in the respected Haaretz daily that the military was preparing to "forcibly evacuate 23 illegal outposts in one day," in a plan drawn up with Netanyahu’s knowledge.
The same Haaretz columnist disclosed plans to remove troops and Jewish settlers from the Gaza Strip before that pullout occurred in 2005.
Separately, a report by the Macro Center of the Israeli European Policy Network said settlements were receiving a larger share of government funding than municipalities inside Israel, and the settler population was also growing three times as fast.
"While Israeli municipalities as a whole receive 34.7 percent of their income from (the government) and obtain another 64.3 percent from their own income, settlement municipalities obtain 57 percent from the (government) and only 42.8 percent from their own income," the report said.
(Additional reporting by Madeline Chambers in Berlin, Niklas Pollard in Stockholm, Mohammed Assadi in Ramallah, and Douglas Hamilton and Ali Sawafta in Jerusalem)