The move was put forward by New Zealand, Malaysia, Venezuela and Senegal to the 15-member body for a vote on Friday evening – but the US abstained.
Previously Egypt had withdrawn its support for the motion after pressure from Israel and US President-elect Donald Trump.
The resolution was passed with 14 votes in favour and was greeted with a round of applause.
It demanded that Israel “immediately and completely cease all settlement activities in the occupied Palestinian territory, including East Jerusalem” and said the establishment of settlements by Israel has “no legal validity and constitutes a flagrant violation under international law.”
However, the news of America abstaining from the vote was met with outrage with US House Speaker Paul Ryan describing it as “absolutely shameful” and a “blow to peace”.
Senator John McCain also said the US move “has made us complicit in this outrageous attack”.
While US President-elect Donald Trump tweeted after the vote: “As to the UN, things will be different after Jan 20th.”
It is the first resolution the Security Council has adopted on Israel and the Palestinians in nearly eight years.
In the aftermath of the vote an Israeli official accused Barack Obama of colluding with the Palestinians in a “shameful move against Israel at the UN” .
The official said: “President Obama and Secretary Kerry are behind this shameful move against Israel at the UN.
“The US administration secretly cooked up with the Palestinians an extreme anti-Israeli resolution behind Israel’s back which would be a tail wind for terror and boycotts and effectively make the Western Wall occupied Palestinian territory.”
Mr Netanyahu said he will not abide by the vote and looks forward to working with Mr Trump to counter any effects of the resolution.
In a statement he said: “The Obama administration not only failed to protect Israel against this gang-up at the UN, it colluded with it behind the scenes.
“Israel looks forward to working with President-elect Trump and with all our friends in Congress, Republicans and Democrats alike, to negate the harmful effects of this absurd resolution.”
While a spokesman for Palestinian President Mahmoud Abbas hailed the UN vote as “a big blow to Israeli policy, a unanimous international condemnation of settlements and a strong support for the two-state solution”.