The British government has for the first time called on all supermarkets to inform customers clearly when they are buying food produced by Israeli settlements in the occupied West Bank.

A Palestinian farmer examines olives in the West Bank. The British government recommends such food be labelled 'Palestinian produce', while that produced by Israeli settlers in the territory be labelled 'Israeli settlement produce'. (Photograph: Abbas Momani/AFP/Getty Images) The new guidance on food labelling significantly increases UK pressure on Israeli settlements, which are illegal under international law, and increases the prospect of consumer boycotts. Israeli officials and settler leaders were tonight highly critical of the decision.

Until now, food has been simply labelled "Produce of the West Bank", but under the new, voluntary guidance issued by the Department for the Environment, Food and Rural Affairs (Defra), labels should in future give more information. It suggested they say "Israeli settlement produce" or "Palestinian produce".

Nearly 500,000 Jewish settlers live in east Jerusalem and the West Bank. The British government and the European Union has repeatedly said Israel's settlement project is an "obstacle to peace" in the Middle East.

EU law already requires a distinction to be made between goods originating in Israel and those from the occupied territories, though pro-Palestinian campaigners say this is not always observed.

Separately, Defra said that traders would be committing an offence if they declared produce from the occupied Palestinian territories as "produce of Israel".

Produce grown in Israeli settlements include herbs sold in UK supermarkets, such as Waitrose, which chop them up, package them and label them as "West Bank" produce, making no distinction between Israelis and Palestinians. A total of 27 Israeli companies operating in settlements and exporting to the UK have been identified: their produce includes fruit, vegetables, cosmetics, pharmaceuticals, plastic and metal items and textiles. Other retailers selling them include Tesco, Sainsbury's, Somerfield, John Lewis and B&Q.

Goods from inside Israel's 1967 borders are entitled to a preferential rate of import duty under an agreement with the EU. Palestinian goods from the West Bank, Gaza and east Jerusalem also enjoy duty-free or reduced tariff treatment. Settlement products fall outside these two categories.

"This is emphatically not about calling for a boycott of Israel," a Foreign Office spokesman said. "We believe that would do nothing to advance the peace process. We oppose any such boycott of Israel. We believe consumers should be able to choose for themselves what produce they buy. We have been very clear both in public and in private that settlements are illegal and an obstacle to peace."

The Trades Union Congress general secretary, Brendan Barber, welcomed the public clarification that marking produce from illegal settlements on occupied territory as "produce of Israel" was against the law, but said the government should have gone further.

"Profiting from the goods produced in the illegal settlements is contrary to international law and they should be banned from sale in the European Union, as they are in Palestine. Trade in such goods undermines the viability of a sovereign Palestinian state and holds back the peace process."Barbara Stocking, Oxfam's chief executive, said: "We support the right of consumers to know the origin of the products they purchase. Trade with Israeli settlements - which are illegal under international law - contributes to their economic viability and serves to legitimise them. It is also clear from our development work in West Bank communities that settlements have led to the denial of rights and create poverty for many Palestinians."

Dani Dayan, the Argentinian-born leader of the Yesha Council, which represents Israeli settlers, said the decision was the "latest hostile step" from Britain. "Products from our communities in Judea and Samaria should be treated as any other Israeli product," he said, using an Israeli term for the West Bank.

Israeli officials said they feared this was a slide towards a broader boycott of Israeli goods. Yigal Palmor, Israel's foreign ministry spokesman, said his country's produce was being unfairly singled out.

"It looks like it is catering to the demands of those whose ultimate goal is the boycott of Israeli products," he said. "The message here will very likely be used by pro-boycott campaigners. It is a matter of concern."

He said the issue of different European customs tariffs should not extend to different labelling on supermarket shelves. "It is a totally different thing and not required by the EU."

Israel came under intense US pressure early this year to halt construction in settlements, but has only adopted a temporary, partial freeze. Palestinian leaders say they will not restart peace negotiations until there is a full settlement freeze in line with the US road map of 2003.

The Palestine Solidarity Campaign said it welcomed the new guidance but urged Defra to go further: "The government must seek prosecutions of companies which smuggle settlement goods in under false labels. We have received many calls from people who were distressed when they bought goods labelled "Produce of the West Bank" because they thought they were aiding the Palestinian economy, then realised they were economically aiding Israel's illegal occupation.

"Particularly following Israel's massacre in Gaza, consumers have been shocked at Israel's war crimes and want to take action. They do not want to feel complicit in Israel's occupation by buying stolen goods."