The Bush administration says it will penalize Israel for expanding settlements in Palestinian areas by making deductions from U.S. loan guarantees that have been promised to the Israeli government. U.S. officials have not yet determined the amount of U.S. aid that will be denied because settlement building.

The deductions for settlement activity were provided for in the legislation that set up a billion, three-year package of U.S. loan guarantees for Israel earlier this year.

But the administration's decision to go ahead and actually penalize Israel, the United States' biggest aid client, is a highly-visible sign of displeasure over settlement-expansion, which has continued despite U.S.-led efforts to implement the international "road map" to an Israeli-Palestinian peace accord.

At a briefing for reporters, State Department spokesman Adam Ereli said the law stipulates that U.S. backed loans can only support Israeli projects within that country's pre-1967 borders.

He said the loan package will be reduced by an amount equivalent to what the United States estimates Israel has spent on settlement building since measure was approved by the Congress last March. "A reduction will be made in accordance with this legislation. The precise amount is still being determined, but will be an estimate based on a range of Israel government expenses associated with the settlement activity."

Mr. Ereli said U.S. officials are still considering whether to penalize Israel with further reductions in the loan guarantees for its construction of a controversial security barrier being put up largely in Palestinian territory near the so-called "green line", Israel's 1967 boundary with the West Bank.

While the United States does not oppose a security fence in principle, Mr. Ereli said the United States has "a problem" with the Israeli project to the extent that it infringes on Palestinian land or pre-judges the borders of a future Palestinian state.

The loan guarantees for Israel were part of a billion supplemental spending package approved by Congress in March to pay for the war in Iraq, and to offset economic harm the conflict may have caused for regional U.S. allies including Israel, Jordan and Turkey.

No additional direct assistance to Israel, which already receives about billion in U.S. military and economic aid each year, is involved. But the United States would stand behind bonds issued by Israel and by extension assure the Israeli government better terms for the borrowing.

Israel intends to begin tapping into the U.S. guarantees with a .6 billion bond issue at the end of this month.