The guidelines set out how farm produce and other goods from the settlements should be labelled if sold in the EU.
Israel has stridently condemned the decision, calling the move disturbing and damaging to peace efforts with the Palestinians.
The new guidelines demand products sold in European Union member states must have clear labels showing their place of origin.
The EU does not recognise Israel's occupation of the West Bank, Gaza, East Jerusalem and the Golan Heights, all captured in the 1967 Middle East war.
The EU now says it is illegal for goods from settlements there to be labelled "Made in Israel".
And its new labelling policy aims to distinguish between goods made inside the internationally accepted borders of Israel and those outside.
But the director general of Israel's foreign-affairs ministry, Dore Gold, says negotiations on a plan to delineate borders should begin before decisions are made on labelling.
"I think the product should be labeled 'Made in Israel', but that doesn't mean that the world is recognising Israel's claims. The only thing that's going to determine the future borders between Israel and a Palestinian state will be direct negotiations between Israel and the Palestinians. What the European Union could do is it could encourage Mahmoud Abbas to go back to the negotiating table, and let's finally, once and for all, decide this issue."
The decision comes at a time of high tension between Israel and the Palestinians.
Violence has, in part, been fuelled by the expansion of the settlements and Israeli occupation of the areas.
Israeli prime minister Binyamin Netanyahu has also criticised the EU, saying the move singles out Israel and potentially harms long-standing peace efforts.
"The labelling of products of the Jewish state by the European Union brings back dark memories. Europe should be ashamed of itself. It took an immoral decision. Of the hundreds of territorial conflicts around the world, it chose to single out Israel and Israel alone, while it's fighting with its back against the wall against a wave of terror. The European Union is not going to hurt the Israeli economy. It's strong enough to weather this. But it's the Palestinian workers in Israeli enterprises in Judea and Samaria (the West Bank) that will be hurt. This will not advance peace. It will certainly not advance truth and justice. It's wrong. Europe should be ashamed of itself."
Since 2004, products from the settlements have not had the benefit of trade preferences to the European Union.
For all countries, the EU has agricultural legislation that requires labelling of the origin of fruit, vegetables and honey.
Industrial goods, including processed food, are not subject to mandatory labelling under EU law but can be voluntary.
Israel's economy ministry estimates the impact will be about AU$70 million a year, affecting fresh produce such as grapes and dates, wine, poultry, honey, olive oil and cosmetics.
That is around one-fifth of the value of the goods produced in the settlements each year.
But it is a much smaller portion of the AU$42 billion of goods and services Israel exports to the EU annually, a third of all its exports.
EU ambassador to Israel Lars Faaborg-Andersen says the EU dismisses any suggestion of a boycott, pointing out it is not telling consumers what to buy.
"This is not a boycott, because how can it be a boycott if the products are allowed to come onto the market as they have done previously also? And there's another important point here. The European Union is against sanctions, against boycotting, against isolation of Israel. And, therefore, the measures that we have taken and which, again, are all based on existing legislation have absolutely nothing to do with that."
The Palestine Liberation Organisation's Moustafa Barghouti has welcomed the guidelines.
"The decision of the European Union to identify the source of production for Israeli products and identify them from settlement products is a very important step and very good step. It confirms the illegality of Israeli settlements. It confirms that Israeli production inside the occupied territories is illegal. And it gives the European person the possibility of boycotting settlement products."
